What Is a 5/6 ARM and How Does It Work?

Adjustable-rate mortgages (ARMs) offer a mix of fixed and variable interest rates, attracting borrowers with initially lower payments. Among these, the 5/6 ARM stands out for its distinctive structure, which can influence financial planning.

Loan Structure

The 5/6 ARM features a fixed interest rate for the first five years, followed by adjustments every six months. This initial fixed period provides payment stability, which can benefit borrowers anticipating changes in their financial circumstances or market conditions. After the fixed-rate phase, the interest rate adjusts based on an index such as the Secured Overnight Financing Rate (SOFR), which reflects broader economic trends. These semi-annual adjustments may result in lower payments if rates fall but also carry the risk of higher payments if rates rise.

Interest Rate Index

The interest rate index determines rate adjustments for a 5/6 ARM. SOFR, a widely adopted benchmark, has replaced the London Interbank Offered Rate (LIBOR). Derived from the Treasury repurchase market, SOFR offers a transparent and reliable measure of borrowing costs. Its responsiveness to economic changes enables lenders to align rates with market conditions. Borrowers should understand how this index affects their payments, as it directly impacts affordability.

Rate Adjustment Caps

Rate adjustment caps limit how much the interest rate can change during each adjustment period and over the loan’s life. A common cap structure, such as 2/1/5, means the rate cannot increase by more than 2% at the first adjustment, 1% during subsequent adjustments, and 5% over the loan’s term. These caps shield borrowers from steep payment increases, offering some predictability. However, they also restrict decreases, which may be less favorable in a declining rate environment. Understanding these caps allows borrowers to better anticipate payment changes.

Monthly Payment Calculations

Monthly payments for a 5/6 ARM depend on several factors. During the fixed-rate period, payments are based on the loan principal, interest rate, and term. Once the adjustable phase begins, the new rate is calculated by adding a fixed margin to the current index value. Borrowers should monitor index fluctuations and consider how adjustment caps influence their payments to ensure affordability.

Qualifying Criteria

Obtaining a 5/6 ARM involves meeting specific lender requirements. Lenders evaluate the borrower’s debt-to-income (DTI) ratio, often using a “stress-tested” rate to account for potential future rate increases. A DTI below 43% is generally preferred, though higher ratios may be accepted with strong compensating factors. Credit score requirements are typically stricter than for fixed-rate loans, with a minimum of 620, though higher scores can secure better terms. Lenders also assess employment stability and income consistency, with self-employed individuals needing detailed financial documentation to verify income reliability.