The 5/5 ARM Loan Just Might be the Best Mortgage Loan

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Want the lower initial interest rate of an adjustable-rate mortgage (ARM) with at least some of the stability of a fixed-rate loan? The 5/5 ARM might be an option.

This relatively new loan is popular among consumers who want low monthly payments but don't want to worry each year that this payment might rise. That's because the interest rate attached to a 5/5 ARM doesn't reset — or adjust — as often as it does with a traditional loan.

Is it Right for You?

That doesn't mean that the 5/5 ARM is the right mortgage choice for all borrowers. Even though there is less financial risk than with traditional ARMs, there is still some.

"As with all ARMs, you are taking a little bit of a gamble," said John Walsh, Chief Executive Officer of Milford, Connecticut-based Total Mortgage. "If after you set your interest rate for five years interest rates start decreasing, then you made the wrong decision. If rates start increasing after you set your initial rate, then you made the right decision for those five years."

Traditional ARMs are attractive because they come with lower initial interest rates. But they also come with higher risk: After a set number of years — often five or seven years, but perhaps as many as 10 — in which the interest rate with an ARM remains unchanged, it then adjusts every year, rising or falling according to which economic indices the ARM is attached to.

An ARM might be tied to the London Interbank Offered Rate, better known by the acronym LIBOR. After an ARM's fixed-rate period ends, each year that loan's interest rate will rise or fall depending on what's happening with the LIBOR index.

There is a bit of a safety net built into most ARMs. They'll usually come with a cap that limits how much monthly payments can rise once the loan enters its adjustable period. An ARM might have a cap of 2% plus the one-year Libor index, for example.

That's complicated, so it's important to ask your lender just how big of a jump your mortgage payment can take during its adjustable years. If you can't handle the maximum possible increase? An ARM might not be for you.

Advantages of a 5/5 ARM

A 5/5 ARM, though, is a bit different. Lenders advertise it as a loan product that combines the stability of a fixed-rate loan with the low initial payments of an ARM.

Like all ARMs, the 5/5 ARM comes with a fixed-rate period. In this version, the interest rate doesn't change for five years. After this set period ends, the rate adjusts. But it then remains at its new level for five more years instead of adjusting every 12 months.

And the 5/5 ARM will continue in this pattern until borrowers pay it off, sell their homes, or refinance to a new loan. The interest rate will remain in place for five years, adjust, remain in place for five more years, adjust, and so on.

Most 5/5 ARMs come with caps, too. If your interest rate cap is 2%, your rate can't rise higher than that level during each adjustment period. This cap is important, letting you calculate your worst-case-scenario payment.

Say you start your 5/5 ARM with an interest rate of 3.25%. If your interest rate cap is 2%, rate can only jump to a maximum of 5.25% when your loan hits its first adjustment period after five years. That comes out to an average interest rate of 4.25% for the first 10 years of this particular 5/5 ARM.

Peter Grabel, Managing Director of Luxury Mortgage Corp. in Stamford, Connecticut, says that a 5/5 ARM might be a good choice for a younger couple looking to buy a first home. The lower initial interest rate means that this younger couple might be able to get into a larger home than they otherwise would have if they instead sought out a traditional fixed-rate mortgage with a higher interest rate.

But borrowers who apply for a 5/5 ARM need to be certain that they can afford the higher mortgage payment that might kick in after five years, Grabel said.

"Maybe five years from now this young couple will be making more money," Grabel said. "They might be able to afford a higher interest rate then. For people willing to take a little gamble, this is a good loan choice: They pay less now while paying potentially more in years six to 10."

Have you considered a 5/5 ARM? Why or why not?