The Veridian Blog

The 5/1 ARM, tarnished for years by bad news press as one of the “exotic” loan programs blamed for the foreclosure crisis, is in our opinion an important loan program that can be extremely advantageous to the financially-savvy borrower.  Because of the unfair label, most moderately conservative borrowers these days opt for the traditional 30-year fixed program.  Part of the reason also is that we feel the 5/1 ARM is not properly or adequately explained to clients as it should be. 

The 5/1 ARM is a hybrid of long-term fixed programs and shorter term adjustable rate mortgages (ARMs).  The program offers a fixed rate and payment during the first 60 monthly payments, or 5 years of the term.  After the initial fixed period, the loan then automatically converts to an ARM which means the interest rate becomes variable for the remainder of the term.  I most cases, the rate will change every 12 months, or one year, based on the sum of a fixed margin and a given index - usually the 12-month T-Bill or the 1-year Libor.  This is the uncertainty that drives most people away – despite the initial low “teaser” rates as well as lifetime and period caps on rate increases.

We generally recommend the 5/1 ARM if the borrower intends on owning the house 8 years or less because that is our estimated “break-even” point after including many factors that most by-the-book lenders don’t: likely increase in income in 5 years (thus absorbing any payment shock), likelihood of refinancing or moving within 5 years (most people move sooner than they plan to), likelihood of paying down principal in 5 years, likelihood of rates going up and staying up in 5+ years (if rates skyrocket after 5 years, remember that the borrower has still built a 5-year cushion of savings).  In other words, it would take a combination of unfortunate occurrences for the decision to apply for the 5/1 ARM to be a financially incorrect one. 

Another factor to consider – the emotional component.  We realize that some borrowers, no matter what sort of analysis is offered, cannot sleep well at night if they do not know what payment is expected for the next 30 years.  And we understand that.  There’s no sense in trying to play the odds if you’re going to accelerate the aging process!

For even more detailed analysis of hybrid-ARMs, indexes and caps, let us know!