5/1 ARM: Lower Payments Worth The Risk?!

5/1 ARM: Lower Payments Worth The Risk?!

The 5/1 ARM has become increasingly popular in recent years, primarily because of its initial lower monthly payments. In a 5/1 ARM (adjustable rate mortgage), the consumer pays a relatively low interest rate for five years (or 60 months), after which the interest rate will adjust to a higher level and will readjust annually until the loan is paid in full.

So when might a 5/1 ARM be a good choice?

  • If you expect your income to increase dramatically within the next five years: For instance, if you’re a student and expect your degree to be conferred within the next five years, handling the possible increased payment may not be a concern.
  • If you expect to move within the next five years: You can enjoy a low monthly payment now, knowing that you’ll move before the initial term expires and the loan readjusts to a possibly higher rate.
  • You have less than perfect credit: In the past, some lenders have been more willing to write a loan with a shorter term to borrowers who have less than ideal credit. If this is you, use the five years to practice good credit habits so you can refinance favorably at the end of the term.
  • You need breathing room in your budget RIGHT NOW.

Although the 5/1 ARM can be a great loan for many individuals, there are significant risks that are worth noting:

  • Your payments will increase significantly at the end of the initial five-year term, so your projected income must be able to handle the increased monthly payment.
  • There’s no way to predict where interest rates will be in five years when the loan readjusts; if rates are significantly higher, you could be in for a much higher payment – even higher than you can comfortably afford.
  • After the initial adjustment, the loan will continue to adjust each year. That means that each year, you’ll have a new – and perhaps higher – monthly payment to make. Of course, that also means that if interest rates fall, your payment could be lower.
  • If you plan to refinance at the end of your initial term and you have poor credit, you may be unable to refinance or you may be forced to accept a much higher interest rate than you would have had using your credit data from five years earlier.

The 5/1 ARM can be a smart choice for some consumers; if you feel an ARM is right for you, be sure to keep your credit in good standing in case you find yourself needing to refinance.