For commercial real estate owners, the 5/1 ARM is a commonly used type of financing. This variety of mortgages carries a fixed rate for five years. After that period, the rate can adjust once a year.
What Is a 5/1 ARM Loan?
A 5/1 ARM is known as a commercial hybrid adjustable rate mortgage. This type of loan starts with a period of fixed interest rates. After the initial period, the rate can then adjust. With a 5/1 ARM, the mortgage rate is fixed for five years. Then, the lender can adjust the rate up or down once a year. The 5/1 ARM is just one flavor of hybrid loans. Lenders also offer 3/1, 7/1 and 10/1 ARMs, which carry fixed rates for the first three, seven or 10 years.
How Does a 5/1 ARM Loan Work?
A 5/1 ARM loan offers a period of fixed rates followed by a period of floating rates. Commercial property owners often take this type of loan with the intention of selling the property and paying off the loan during the first five years. Or perhaps they’ll refinance after five years. The loans typically come with a 25- or 30-year amortization schedule. The payment is recalculated as the rate adjusts.
Example of 5/1 ARM Loan
Say you borrow $1 million with a 5/1 ARM at a 7% interest rate and a 30-year amortization schedule. Your monthly payment for the first five years would be $6,653. Say you still have the loan in year six, and rates have risen enough that your interest rate climbs to 9%. In that scenario, your payment would climb to $8,046. If, on the other hand, rates fall and your mortgage rate dips to 5%, your monthly payment would be $5,368.
What Should I Look For When Shopping For A 5/1 ARM?
There are a number of variables to keep in mind when shopping for 5/1 ARMs. The most obvious factor is the rate during the fixed-rate period. But borrowers also should look at how much the rate can move when it goes into the ARM period. Lenders typically cap the adjustments to 2 percentage points. Other factors include closing costs and lender fees. Underwriting guidelines also are something you should consider: What are the lender’s requirements regarding the borrower’s credit score and loan-to-value ratio? And how much are the loan’s prepayment penalties?
When does a 5/1 ARM adjust?
Your loan documents spell out the details, but in general, a 5/1 ARM carries a fixed rate for the first five years. Then, after the 60th payment, the rate adjusts depending on the overall interest rate market. If you keep the loan during the floating-rate period, your interest rate changes once a year.
What Index Does a 5/1 ARM Mortgage Use?
For decades, adjustable-rate mortgages were indexed off the London Interbank Offer Rate or LIBOR. However, a 2012 scandal involving the manipulation of LIBOR tainted the index. In recent years, LIBOR has been replaced by the Secured Overnight Financing Rate or SOFR. This rate measures the cost of overnight borrowing collateralized by US Treasury instruments in the overnight repo market. Your lender will spell out the spread between your mortgage rate and SOFR
Pros and Cons of 5/1 ARM Loan
- Favorable rate: The initial interest rate for the fixed period of the loan is lower than the rate would be on a mortgage that’s fixed for 30 years.
- Predictability: For the first five years of a 5/1 ARM, the borrower enjoys stable payments.
- Future rate increases: After five years, your payment can go up – if the overall rate environment has increased.
- Future refinances: If you still own the property in five years, you might opt to refinance your loan, a process that requires time and money.
Is a 5/1 ARM Loan Right For You?
A 5/1 ARM is a good choice for many borrowers, particularly those who want a period of payment stability. If you plan to keep a property for decades, a fixed-rate loan might be a better choice. But if you expect to sell or refinance in five years, then the 5/1 ARM is a compelling option.
Frequently Asked Questions (FAQ)
Can you refinance from ARM to fixed?
Yes, as long as you can find a lender willing to offer a fixed-rate mortgage. Most commercial mortgages are ARMs, but fixed-rate loans are available.
What happens at the end of an ARM mortgage?
In the unlikely event that you keep an ARM to the end of the 25- or 30-year amortization schedule and you make regular monthly payments, you will have paid off the entire loan amount.
Can you pay off a 5/1 ARM early?
Yes, you can pay off the loan early, either by selling the property or refinancing the original loan. Many 5/1 ARMs come with prepayment penalties.
Are 5/1 ARM loans good?
A 5/1 ARM appeals to many borrowers by combining rate stability with favorable interest rates. So, yes, these loans are a good deal for many property owners. An unknown is where rates will be five years from now. If interest rates have risen, your payment will go up. However, if interest rates fall, so will your monthly payment.
What is the difference between a 5/1 and a 7/1 ARM?
A 5/1 ARM carries a fixed interest rate for five years before adjusting. A 7/1 ARM is similar, except that the period of fixed interest rates lasts for seven years.
What is a 5/1 ARM interest-only loan?
An interest-only loan lets the borrower pay only interest but no principal for a set period of time. In the case of a 5/1 interest-only ARM, the borrower would pay only interest for five years, and then the loan would adjust to a typical amortization schedule. This feature appeals to payment-sensitive borrowers who want the lowest possible monthly payment.