What is a 5/1 ARM (adjustable rate mortgage)?

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In Chapter 4 of Home Buying In 30 Minutes, I described how some buyers might want to get an adjustable-rate mortgage (ARM) — a loan product that offers low introductory rates that are later adjusted based on current interest rates. While ARM rates can adjust either up or down, since rates are currently near historic lows and are widely expected to rise, you can expect the payments on an ARM to increase over time. Below I will describe how ARMs work and what is a 5/1 ARM.

Most people’s incomes rise over time, too. If you think your income will increase enough to cover the cost of the higher payments in subsequent years, an ARM could work for you.

Median sales price of existing homes - impact on interest rates 5/1 ARM?

Home pries have been rising in the U.S., but so have interest rates, which means ARMs can adjust to much higher rates for people holding them. Source: NAR

On the other hand, payments in an ARM can rise substantially over the life of the loan. The lower initial payments are attractive to buyers, but they come with the risk of much higher payments later. This is especially true in a rising interest rate environment like the one we’re currently in.

ARMs can be a good choice for first-time buyers who don’t plan to own the property for more than a few years. Of course, if plans change and they wind up owning the property for longer than expected, they might be able to refinance into a fixed-rate mortgage before the ARM payments balloon.

A 5/1 ARM means the introductory interest rate remains constant for the first 5 years of the loan. After that, the interest rate changes (either up or down) no more than once per year. A 3/6 ARM means the rate is fixed for 3 years, and thereafter adjusts every 6 months. Typically, there is an annual cap (meaning the interest rate can’t go up or down more than a certain percent in any given year) and a lifetime cap (meaning the rate can never exceed a certain range, regardless of what the index does). There are also 7- and 10-year adjustable rate ARMs.

Why are mortgages necessary?

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As I explained in Chapter 4 of Home Buying In 30 Minutes, few first-time homebuyers are able to buy a house or condo in an all-cash deal. Typically, a young couple will be able to afford a relatively small down payment (say, $20,000) and pay the remainder of the cost of the home (say, $200,000) using a type of bank loan called a mortgage. This post describes mortgages and requirements related to mortgages.

Second-time homebuyers moving into a larger home will be able to pony up larger down payments through the sale of their smaller first home, but will still need to take out a new mortgage (after paying off the remaining loan amount from the mortgage on the first home). If you are a downsizing empty-nester, or moving from an expensive market to an inexpensive market, you may be able to pay for the cost of the new home through the sale of your old home, maybe even with some cash left over!

Signing of mortgage documents. Credit: Depositphotos

Signing mortgage documentation

When planning to take out a mortgage, be prepared for banks to look at your credit score, recent tax returns, bank account statements, and pay stubs. They want to have confidence that you will be able to make the monthly payments, and may say “no” if they see something in your application that gives them pause.

If your home buying plans are still a few years out, you have some time to consolidate credit card debt, pay off some past-due utility bills, and reduce luxury purchases, which will positively impact your credit score. To see potential problem areas and correct errors in your score, request a copy of your credit report (free in many states) from one of the major credit bureaus: Experian, Transunion, and Equifax.

Remember that there may be other monthly costs associated with the purchase that can significantly impact your finances. They include local property taxes charged by the city or town, which can often be added to monthly mortgage payments. Other costs include fees charged by condo associations and planned communities, and certain types of insurance. These costs will vary according to the home you choose to buy and local factors.