A five year mortgage, sometimes called a 5/1 ARM, is designed to give you much of the stability of payment as you'd get with a 30 year fixed rate mortgage, but also allows you to qualify at and pay at a lower rate of interest for the first five years. There are also 5 year balloon mortgages, which require a full principle payment at the end of 5 years, but generally are not offered by commercial lenders in the current residential housing market.
Teaser rates on a 5 year mortgage are higher than rates on 1 or 3 year ARMs, but they're generally lower than rates on a 7 year ARM or a fixed rate mortgage. A 5 year could be a good choice for those buying a starter home who want to increase their buying power and are planning to trade up in a few years, but who wish to avoid a lot of volatility in their payment levels.
5 year ARMs, like 1 and 3 year ARMs, are based on various indices, so when the general trend is for upward rates, the teaser rates on adjustable rate mortgages will also rise. Currently rates are low, because the Fed has bought a lot of mortgage backed securities in order to take bad assets off bank balance sheets.
5 year ARMs are most often tied to the 1 year Treasury or the LIBOR (London Inter Bank Rate) but it's possible that any particular ARM could be tied to a different index. These are the most common indices that banks use for mortgage indices:
The initial rate, called the initial indexed rate, is a fixed percentage amount above the index the loan is based upon at time of origination. This amount added to the index is called the margin. Subsequent payments at time of adjustment will be based on the indexed rate at time of adjustment plus the fixed percentage amount, same as it was calculated for the initial indexed rate, but within whatever payment rate caps are specified by the loan terms. Though you pay that initial indexed rate for the first five years of the life of the loan, the actual indexed rate of the loan can vary. It's important to know how the loan is structured, and how it's amortized during the initial 5 year period.
Payment rate caps on 5/1 ARM mortgages are usually to a maximum of a 2% interest rate increase at time of adjustment, and to a maximum of 5% interest rate increase over the initial indexed rate over the life of the loan, though there are some 5 year mortgages which vary from this standard. Some five year loans have a higher initial adjustment cap, allowing the lender to raise the rate more for the first adjustment than at subsequent adjustments. It's important to know whether the loans you are considering have a higher initial adjustment cap.
In analyzing different 5 year mortgages, you might wonder which index is better. In truth, there are no good or bad indexes, and when compared at macro levels, there aren't huge differences. Each has advantages and disadvantages. One of the things to assess when looking at adjustable rate mortgages is whether we're likely to be in a rising rate market or a declining rate market. A loan tied to a lagging index, such as COFI, is more desirable when rates are rising, since the index rate will lag behind other indicators. During periods of declining rates you're better off with a mortgage tied to a leading index. But due to the long initial period of a 5/1 ARM, this is less important than it would be with a 1 year ARM, since no one can accurately predict where interest rates will be five years from now. With a 5/1 loan, though the index used should be factored in, other factors should hold more weight in the decision of which product to choose. The index does affect the teaser rate offered.
Knowing what type of mortgage you're getting can be a challenge, since so many things that sound like a good idea are often the things that can cost you the most money.
Though 5 year loans are all lumped together under the term "five year loan" or "5/1 ARM" there are, in truth, more than one type of loan under this heading. Understanding which of these types are available could save your wallet some grief in the future. Some types of 5 year mortgages have the potential for negative amortization.
Negative amortization, to put it simply, is when you end up owing more money than you initially borrowed, because your payments haven't been paying off any principle. Negative amortization can be especially devastating in times of dropping real estate values, since the total amount you owe on the mortgage is increasing while the value of the property is dropping, decreasing your equity stake. When the value of the property falls below the amount owed, this is called being "under water."
There are three types of 5-year mortgages: Hybrid ARM, Interest-only ARM and Payment-option ARM.
Here's a comparison of the three different types of ARM and a 30 year fixed mortgage payments, with all other things being equal, assuming an adjustment to the maximum payment cap: