When it comes to mortgages, there is no one-size-fits-all solution. But there are lots of options. And your job as a borrower is to understand all your options. When you apply for financing to buy a home, an adjustable-rate mortgage (ARM loan or ARM) may be one of your options. And a 5/6 ARM is one of the most common adjustable-rate loan options available.
If you’re considering a 5/6 ARM, we’re here to help. Read on to learn what an ARM is and what an adjustable interest rate means for your current and future finances.
What Is an ARM Loan?
An ARM is a mortgage that typically has a fixed interest rate for a set number of years. After that, the mortgage rate changes periodically until the loan is paid off.
ARMs are usually expressed in two numbers. The first number is the number of years you’ll pay the fixed rate (also called the initial fixed-rate period or introductory period). The second number is the adjustment period (or adjustable-rate period). The second number indicates how often your interest rate will adjust after the introductory period.
Banks and other private lenders offer different types of ARMs. You may qualify for a 5/5 ARM, a 7/6 ARM or a 10/6 ARM.
In many cases, a borrower can get a lower introductory interest rate with an ARM than with a fixed-rate mortgage. However, that can change quickly after the introductory period ends.
How Does a 5/6 ARM Work?
A 5/6 ARM is an adjustable-rate mortgage that has a fixed interest rate for 5 years. After that, the rate can change every 6 months. Most 5/6 ARMs have a total loan term (repayment period) of 30 years.
The first 5 years of a 5/6 ARM are predictable. The interest rate is fixed, so every monthly mortgage payment is the same. You can find the fixed rate (the initial interest rate) in your Loan Estimate.
In year 6, things start to get interesting. The interest rate adjusts every 6 months based on two factors: the index rate and the margin.
- The index rate: Is a benchmark interest rate. Your lender will choose a specific market index, such as the U.S. prime rate or the Constant Maturity Treasury (CMT) rate. Your interest rates will usually adjust up or down based on changes in the index.
- The margin: Is the set number of percentage points your lender adds to the index rate. This number is set when you get the Loan Estimate, and it never changes.
To calculate your new interest rate, which is called the “fully indexed rate,” the lender adds the index to the margin. If your margin is 2% (2 percentage points) and the index is 4%, you’ll pay a fully indexed rate of 6% in interest. Your lender can change the interest rate every 6 months.
If you meet certain qualifications, you might be able to save money by negotiating with your lender for a lower margin on an ARM.
To protect borrowers from steep interest rate increases, your lender sets an interest rate cap. The cap limits the maximum interest rate you can be charged (also known as the ceiling) and each rate adjustment.
Adjustment period (adjustable-rate period)
While you’re looking at different ARM options, it’s a good idea to think about the adjustment period. With a 5/6 ARM, your interest rate and your monthly mortgage payment can change every 6 months after 5 years. If the index rates drop after the adjustment period, you’ll save money. If the rates increase, your loan will cost you more money.
Compare that to a home loan with a longer adjustment period, such as a 5/1 ARM. If your interest-rate adjustment happens when the index rates are low, you’ll lock in the cost savings for a full year as opposed to 6 months with a 5/6 ARM.
But the opposite is also true. If the rate change for your 5/1 ARM happens when rates are high, you could be locking in a higher interest rate for a year. With a 5/6 ARM, the higher interest rate may change after 6 months.
5/6 ARM rates vs. fixed rates
When you’re shopping for a mortgage loan, you may need to choose between a fixed-rate mortgage and an ARM. With a fixed-rate mortgage, the interest rate stays the same for the lifetime of the loan. With a 5/6 ARM, your interest rate can go up or down twice a year starting in year 6.
To make sure your ARM payments don’t get out of control, lenders typically use a cap structure. Caps set limits on the interest rate. There are a few caps to consider:
- Initial cap: This cap lays out the maximum increase a lender can make on the first adjustment to your interest rate. If your fixed mortgage rate is 3% and the initial cap is set at 1 percentage point, the lender can’t charge more than 4% in interest – regardless of the index rate.
- Per-period (periodic) cap: The cap limits how much a lender can increase your interest rates every adjustment period.
- Lifetime cap: The lifetime cap is the maximum possible increase in the interest rate. This number helps you figure out the maximum interest rate your bank can charge. If your initial fixed rate was 3% and you have a 5% lifetime adjustment cap, your maximum interest rate (the ceiling) is 8%. You’ll never pay more than 8%, no matter what happens with the index.
You can usually find these caps in the adjustable interest rate (AIR) table on your Loan Estimate.
How does this play out in the real world? Let’s game it out.
Say your lender offers you a 5/6 ARM with an initial rate of 3.5%. Your margin is 2%, each increase is capped at 2% and the ceiling on your interest rate is 8%.
Years 1 – 5
- You pay a fixed interest rate of 3.5%.
- First 6 months: The index rises to 4%. Because your rate increases are capped at 2%, your interest rate increases to 5.5% (3.5% initial rate + 2% maximum periodic increase).
- Second 6 months: The index is still at 4%, so your rate rises to a fully indexed rate of 6% (2% margin + 4% index).
- First 6 months: The index jumps to 6%, so your interest rate becomes 8% (2% margin + 6% index).
- Second 6 months: The index climbs to 7%. Because your interest rate ceiling is 8%, your rate doesn’t increase, and you continue to pay 8%.
In this scenario, your interest rate increases from 3.5% to 8% between the end of year 5 and the start of year 7. Depending on how much you borrowed, your monthly payments could rise by $500 or more.
Have you noticed that while the index changes, the margin stays the same? That’s why it’s so important to look at the margin when you’re comparing ARM options. A lower margin means a lower monthly payment and reduced interest overall.
Now, let’s imagine that you’re comparing the 5/6 ARM with the 3.5% initial rate to a 30-year fixed-rate mortgage loan with a 5.5% interest rate. It’s helpful to look at three factors:
- Payments in the first 5 years: If you choose the fixed-rate mortgage, you’ll pay 2% more in interest for the first 5 years. If you’re borrowing $200,000 at 5.5% interest, your monthly payment before mortgage insurance and taxes will be around $1,136. With the 5/6 ARM, you’ll pay around $898 every month for the first 5 years.
- Payments from years 6 – 30: With the fixed-rate loan, the monthly mortgage payments would always be $1,136. If you chose the ARM and the rates rise to the 8% ceiling, you could end up paying $1,468 a month.
- The total cost of the loan: As interest rates rise on an ARM, the total cost of your loan increases. You may end up paying tens of thousands of dollars more in interest over the life of the loan.
How Are Adjustable-Rate Mortgages Indexed?
The index is a crucial part of an ARM. The specific index that’s linked to your loan impacts how much you pay in interest.
Many ARMs use one of two common index rates:
- The U.S. prime rate: This rate is determined by the American banking system and the federal funds rate. It represents the base-level interest rate across the country.
- One-year Constant Maturity Treasury (CMT) rate: This index is tied to the value of U.S. Treasury securities. It expresses how much interest you might earn from securities in one year based on the trends from recent trades.
Your lender may use another index, such as the Monthly Treasury Average (MTA), the Fannie Mae 30/60 or the 10-year Treasury security. The London Interbank Offered Rate (LIBOR) was once a popular index but is being phased out because of alleged inaccuracies and manipulation.
When your ARM’s underlying index goes up or down, your lender adjusts the interest rate on your mortgage loan accordingly. Look at the history of an index to get an idea of its typical movement patterns. Your research may give you an idea of how your interest rates might change over the life of your loan.
For example, the U.S. prime rate changes with the economy, usually when the Federal Open Market Committee (FOMC) adjusts the federal funds rate. Since a small shift in the federal funds rate would have a big impact on the economy, the FOMC rarely makes big or unexpected changes. That means interest rate increases are usually small, and you’ll know about them in advance.
Index trends can also affect other parts of an ARM. If your index tends to be low, your lender might use a higher margin to compensate.
What Are the Advantages and Disadvantages of a 5/6 Arm Loan?
Like any mortgage, a 5/6 ARM has its advantages and disadvantages. Because ARMs aren’t created equal, before you choose one, consider how the loan compares to other options.
Advantages of a 5/6 ARM
One of the biggest perks of a 5/6 ARM is the initial interest rate. Lenders often give you a lower interest rate than you’d get with other mortgages, including a fixed-rate loan, 10/6 ARM and 7/6 ARM. If you’re thinking of selling your house during that 5-year initial period, the lower interest rate can help you save a considerable amount of money. The introductory interest rate can also be attractive if you’re buying a starter home, just beginning your career or dealing with a low credit score. It gives you 5 years of low payments. After that, you might be in a better position to refinance or handle a higher monthly mortgage payment.
Although the interest rate is variable starting in year 6, most lenders offer caps to keep interest rates in check. If you can comfortably handle the maximum monthly mortgage payment, the initial interest savings might be worth the risk of an interest rate increase after the introductory period.
Disadvantages of a 5/6 ARM
If you’re anxious about the unpredictability of ARMs, you’re not alone. There are two main disadvantages with 5/6 ARMs:
- The 6-month adjustment period means that your monthly payment could increase twice a year if the rate keeps climbing. This can make the loan less attractive, especially if your other options are a fixed-rate loan or a 5/1 ARM. If the index rises, you may end up with significantly higher payments.
- If you like knowing what your monthly mortgage payment will be for years, or even for one year, a 5/6 ARM and its twice-a-year adjustments may not be for you.
Interest rate caps can help protect a borrower from dramatic monthly mortgage payment increases, but it’s always a good idea to check the maximum interest rate. Most lenders disclose the maximum monthly payment. Make sure you can afford it before agreeing to an ARM.
Another way to potentially avoid high interest rates is to sell the house or refinance your mortgage before the 5-year initial rate period ends. And yes, it’s possible to pay off a 5/6 ARM early, but be sure to read the fine print. Lenders may charge a mortgage prepayment penalty.
Is a 5/6 Arm Right for You?
The right mortgage for you depends on your current finances and your future plans. If you want affordable payments for a few years, a 5/6 ARM could be the right choice. If payment predictability is important, a fixed-rate loan might be a better solution.
As you consider a 5/6 ARM, ask yourself these questions:
- Are you planning to sell the house before the 5-year introductory period is up?
- By how much will your payments increase after the first adjustment?
- Are there caps on the interest rate?
- Can you afford the maximum monthly mortgage payment?
- Can you easily adjust your finances to accommodate any potential changes to your monthly mortgage payment every 6 months?
- When will the bank notify you of a payment adjustment?
- Is your income going to be predictable for the next 10 – 20 years?
5, 6, 7, 8, Find the Rate That’s Right for You
The mortgage you choose will impact your finances in the present and the future. Whether you choose a 5/6 ARM, another type of ARM or a fixed-rate loan, read the fine print and compare your options.