A 5-year ARM is an adjustable-rate mortgage that maintains a fixed interest rate during the first 5 years of the loan. A typical structure is depicted as 5/1. This format means that after the initial fixed-rate period, the interest rate is adjusted once per year.
A primary reason people opt for a 5/1 ARM is that the upfront interest rate is typically lower than the rate on a 30-year fixed mortgage. Thus, someone investing in a property for a short time or planning to move within a few years may want to take advantage of the low introductory rate. The ARM makes sense when it is expected that interest will fall going forward. Another reason people go with a 5-year ARM is because they anticipate making more income by the time the interest rate adjusts. This thinking may lead to future financial risks.
A major risk of the 5-year ARM is that interest rate adjustments can dramatically boost monthly payments if the prime rate rises over time. Another drawback is that an interest-rate hike can slow down the process of building equity in the property. When the rate goes up, the amount of a monthly payment that goes toward principal declines.