5/1 ARM Vs. 30-Year Mortgage
You can buy or refinance a home with either a 5/1 adjustable-rate mortgage or a 30-year fixed-rate mortgage. Both types actually last for 30 years; otherwise, there are many differences between the two loan types. Consider factors such as how long you plan to stay in your home and the monthly payment you can afford before you decide which mortgage to use.
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Interest Rate
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Interest rates on 30-year fixed-rate mortgages are based on the yields on 10-year Treasury bonds. Your interest rate remains the same over the entire term of the loan. Interest rates on 5/1 ARMs are usually based on bond yields, although some are based on the London Interbank Offered Rate, an index that reflects the average cost of borrowing in England. Your lender locks your rate for the first five years, but thereafter it changes on an annual basis and moves up or down in conjunction with the index the lender used to price your mortgage.
Payment
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Your monthly payment on a 30-year fixed-rate mortgage never changes, although if you escrow you might see some payment fluctuation due to changes in the cost of insurance and property taxes. The payment on a 5/1 AMR remains steady for the first five years of the loan but changes on an annual basis for the rest of the loan term. 5/1 ARMs normally have payment floors and ceilings that restrict the amount that your mortgage payment can increase or decrease.
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Amortization
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A 30-year fixed rate loan amortizes, which means the principal owed decreases over the term of the loan until you have paid it off after 30 years. On a 5/1 ARM, your principal could increase during the term of the loan, which means your loan could become a negative amortization loan. This can occur if interest rate increases necessitate a payment increase beyond the maximum payment allowed under the terms of your mortgage. Your monthly payments are then insufficient to cover the principal and interest and the lender adds the unpaid interest back to your principal balance.
Considerations
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The interest rates on 5/1 ARMS are usually lower than the rates offered on fixed-rate mortgages during the first five years of the loan. If you plan to own a home for less than five years, you could save money by taking out a 5/1 ARM as opposed to a fixed-rate loan. However, if you take out a fixed-rate loan, your payment always stays steady, which means that as time goes by, inflation and increases in wages mean that your mortgage payment amounts to a smaller and smaller percentage of your monthly income. Therefore, despite savings in the first few years, fixed-rate mortgages are usually the best option for the long term.
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