For most people buying a home is the most expensive purchase. Many people have savings to buy a house, while most have to take a loan or mortgage the house. 5/1 ARM loan is one of those people take to buy houses. If you don’t know about it, this article will help you.
What is a 5/1 ARM Loan?
If you are new in the real estate business, you may have no idea about this loan. ARM stands for Adjustable Rate Mortgage loan. It is a mortgage loan with an adjustable-rate. The loan is fixed for 30 years, but the mortgage rate is adjustable. Buyers and investors agree to a certain period for which the interest rate will be fixed. Usually, this period is five years. After five years' different indicators are analyzed, and the interest rate is fixed for the next five years.
Common indicators used to determine the interest rate are as follows
Cost of Funds Index or COFI
Secured Overnight financing rate or SOFR
Constant Maturity Treasuries or CMT
These loans are for 30 years, but the duration can be reduced.
Fixed-rate mortgage VS adjustable rate Mortgage loan
To understand 1/5 ARM loans, you also need to understand fix rate Mortgage loans. A fixed-rate mortgage is the house loan you take to buy a house and pay installments over a specific period. The loan duration is usually 30 years, and the interest rate is fixed for the entire duration. It is a popular type of loan, as people with economical monthly income can easily adjust the monthly installment within their budget. The drawback is the higher interest rate, but as the duration is for 30 years, people don't mind paying a high-interest rate.
On the other hand, an Adjustable Mortgage loan is risky and unstable. The interest rate is not fixed; rather, it varies based on different indicators. Different economic factors are involved in determining these indicators. These indicators vary according to the market fluctuations. If the market is facing a recession, index rates will be higher, resulting in a very high-interest rate.
5/1 ARM loan is the combination of these two loans. If you take a loan, the interest rate will be lower than standard loans, and it will be fixed for the first five years. After five years, experts will determine the new interest rate based on indices. The interest rate may increase, but it can only be increased once a year.
You can understand it better with an example. Suppose you have purchased a property for a fixed mortgage loan. The price of the property is $250,000, and the interest rate will be 4% for the whole 30 years. The total interest you will pay will be $1,194 approx. If you take a 5/1 ARM loan, the interest rate for the first five years will be lower, $ 1,122.6 for five years. After that, the interest rate will change every year.
Pros of taking a 5/1 ARM loan
Every real estate investor wants to make a profit. Some choose to rent out properties while others flip them. Everyone has a different path to making a profit. If you have a good understanding of the market and use the tools properly, you can earn well. However, make sure you have the correct data and information. Here are some advantages of a 5/1 ARM loan, which you can also enjoy.
Suitable for short-term ownership: If you want to hold the property for a short period, this is the most suitable choice you have.
Lower interest rate: The interest rate for this loan is low for the first five years. You can save this money to furnish the house or invest somewhere else.
Pay principal early: ARM loans have no penalties like other types of loans. You can easily pay back the principal amount.
Cons of 5/1 ARM loan
Like anything else, a 5/1 ARM loan also has some disadvantages. Indeed, this loan is not for everyone. Here are some cons of taking a 5/1 ARM loan.
Does not work for long-term ownership: If you want to hold the property for a longer period, you must avoid taking a 5/1 ARM loan. It comes with an initial lower interest rate, but it can be very high depending on the market. So, you may pay high interest, which is not a wise move.
Refinancing is expensive: You can refinance the house, but the interest rate will be high. You also have to pay a high closing cost, which can be as high as 6%.
Interest rate is unpredictable: Things will be smooth for the first five years when there is a low-interest rate. However, after that, there can be a great risk every year. Usually, the interest rate increases every year. If you cannot pay installments in time, it will affect your credit score.
When should you take a 5/1 ARM loan?
Usually, investors are always confused about the 5/1 ARM loan. If you want to hold the property for a short time, you can consider this loan. If you want to use the property for rental purposes, it means you want to keep it for long. In this situation, avoid a 5/1 ARM loan. On the other hand, if you want to flip the house, there is nothing better than this loan.
We live in the digital era, and various online tools are available to help you. These tools can help you locate the property, analyze different property data and calculate interest rates and taxes.
If you want to get a 5/1 ARM loan, you should consider the fixed-rate period, intervals of adjustment, and initial cap. A lifetime cape and subsequent adjustment cap are also important to consider. You can also assume that if the market is good, your interest rate can be lower even after five years; however, it can be risky.
In short, take a 5/1 ARM loan; if you have to flip the house within a year or so, if you want to keep it, try something else.