An adjustable rate mortgage (ARM) is a type of loan that has an interest rate which can change according to a schedule. A 5/1 ARM mortgage is a type of hybrid that offers a fixed rate period for five years, signified by the "5", after which the rate can be adjusted. After five years have passed, this type of mortgage will have its interest adjusted annually for the rest of the loan term, signified by the "1". The amount the interest rate can increase is usually capped according to the loan terms.
The general purpose of an ARM is to let the borrower make lower payments at the beginning of the loan. ARMs are typically offered at a somewhat lower interest rate than fixed rate loans because the borrower is assuming some risk of the rate rising in the future. Hybrid loans like the 5/1 ARM mortgage are popular because they behave like a fixed rate loan for five years. If interest rates have dropped by the time five years go by, the borrower might choose to refinance into a fixed rate loan. He may also choose to refinance if his credit has improved.
Hybrid loans can also be be attractive if a buyer intends to sell a home before the initial adjustment period because this may represent a large savings of money over that time period. Many ARMs do not carry prepayment penalties, though hybrids are often an exception. If the hybrid ARM has a prepayment penalty, paying off the loan before a certain number of years have gone by may cost the homeowner a lot of money.
Any adjustable rate loan that is identified by two figures with a slash between them follows the same format as a 5/1 ARM mortgage, so a 3/1 ARM would adjust for the first time after three years. An exception is a figure such as 3/6, since the six will typically represent months instead of years. A hybrid loan that has a six in this position will usually have the interest rate adjusted twice each year.
In addition to these two numbers, a 5/1 ARM mortgage and any other adjustable rate loan will typically have three other numbers associated with it. These numbers will usually represent the interest cap structure. For instance, a figure such as 1/1/6 would indicate a loan that has an initial adjustment cap of one percent. This means that a 5/1 ARM mortgage could have its interest rate increased by a maximum of one percent after five years. One year after that it could be increased by one more percent, up to a maximum of six percent over the entire lifetime of the loan.