Homeowners in California have several ways to convert their home equity into cash. One common…
Using a 5-Year ARM Loan to Buy a Home in the Bay Area
Some home buyers in the San Francisco Bay Area use the 5-year adjustable-rate mortgage (ARM) loan to finance their purchases. This is a unique type of home loan that might work well in specific situations. But it’s not for everyone.
In this article, we’ll examine the reasons why you might use a 5-year ARM loan when buying a house in the Bay Area. We’ll look at the pros and cons, common features, terminology and more.
How the 5/1 ARM Loan Works
When it comes to interest rates, there are two main categories of mortgage loans. Fixed and adjustable.
A fixed-rate home loan carries the same interest rate for the entire repayment term. Many homeowners find this option appealing, for obvious reasons. It offers long-term predictability. The 30-year fixed-rate mortgage (FRM) is by far the most popular method of financing among home buyers in the Bay Area and nationwide.
An adjustable mortgage, on the other hand, has an interest rate that will eventually start to change or “adjust” on a recurring basis. There are several different types of ARM loans available to borrowers. The primary difference between them is (A) the length of the initial fixed-rate period, and (B) the frequency of adjustments after the initial period has expired.
Most lenders today offer “hybrid” adjustable loans, and the 5/1 ARM is a good example. They are called hybrids because they start off like a fixed-rate mortgage, before switching into an adjustable product. They are not purely one or the other, but a little of both.
Here’s how the 5/1 hybrid ARM loan works:
This type of mortgage starts off with a fixed interest rate for the first five years. That’s what the number ‘5’ designates in the label. During this initial phase, the loan essentially behaves like a fixed-rate product. The interest rate stays the same. So there is some degree of stability with these products, at least initially.
After the first five years, however, the interest rate will begin to adjust or change. The rate changes annually, or every one year (until the home is either sold or refinanced, or the loan is paid off). That’s what the number ‘1’ designates in the label. So the 5/1 designation tells you this loan has a fixed rate for a period of five years, after which it will adjust every one year.
That’s how the 5-year adjustable mortgage works, in a nutshell. Let’s move on to talk about the pros and cons of using a 5/1 ARM when buying a home in the San Francisco Bay Area.
Advantage: Lower Rates During the Initial Phase
One of the benefits of the 5/1 ARM is that they usually offer a lower rate during the initial phase, when compared to a standard 30-year fixed mortgage product.
For example, if you refer to the Primary Mortgage Market Survey (PMMS) on Freddie Mac’s website, you will see the average interest rates for the current week across three categories: 30-year fixed, 15-year fixed, and 5/1 ARM.
You might also notice that the average rate assigned to the 5-year ARM is lower than the 30-year fixed mortgage. When this article was published, in early October 2021, the average rate for a 5/1 ARM was 2.52% — nearly half a percent lower than the 30-year fixed.
When you secure a lower interest rate on a home loan, you end up with a lower monthly payment as well. That’s an important consideration in any real estate market, but especially one as expensive as ours.
So that’s the primary advantage of using a 5/1 adjustable loan in the Bay Area. It offers a more attractive interest rate during the first five years of the repayment term, when compared to the “standard” 30-year option. That’s the main reason why borrowers choose this product in the first place.
Related: ARM loan guide for Bay Area borrowers
Disadvantage: Uncertainty Over the Long Term
Due to their adjustable nature, 5-year ARM loans are more unpredictable over the long-term.
You’ll know exactly what your interest rate will be for the first five years. You’ll also know that it won’t change or fluctuate during that time period. So your monthly payments will remain static. But you won’t know exactly how the interest rate will behave over the long term.
That’s the primary disadvantage of using a 5/1 ARM loan to buy a home in the Bay Area. It brings more uncertainty over the long run, when compared to the fixed-rate home loans.
Using an Adjustable Mortgage in the Bay Area
So, when does it make sense to use a 5-year adjustable mortgage? To answer this question, you have to think about your long-term plans and how comfortable you are with risk.
- How long do you plan to stay in the home? If you’re planning to stay for many years, you might be better off using a fixed-rate mortgage that offers long-term stability.
- On the other hand, if you only plan to keep the mortgage for a few years before either selling or refinancing, you might benefit from using a 5/1 ARM loan with an initially lower interest rate.
Disclaimer: Despite the length of this article, we haven’t covered every aspect of the adjustable mortgage. This article is meant to give you a general understanding of how these products work. If you have questions about using a 5-year ARM loan in the Bay Area, please contact our staff.
