A 5/1 option ARM is an adjustable mortgage. In most cases, it would adjust after the 60th month. Most adjustments allow for the rate to adjust 2 times the first years with a cap on an adjustment that also factors in a max cap based on the start rate.
Most ARMs adjust to an index’s rate plus the margin factor that the bank or broker charged you.
The option part of this would mean that you are looking at a hybrid ARM which means that you might have 3 or 4 options each month to make a payment. Option 1 might be based on a 30 year fixed schedule, opt 2 might be 15 years fixed, opt3 would be interest only and option 4 would be a negative amortization (means that you would have a mimium payment and the the rest of the payment owed would be added to the balance of the loan).
This option ARM is a great tool if you are very secure with the appreciation of your home and you are either paying down other debt with the savings or are investing the savings.
This is one type of ARM that is currently killing the housing market as in most cases, the borrower owes more than the house is worth.
This should only be used if you are buying a 500K house or higher and are putting 20 to 40% down and using the savings to invest or pay down debt. Not to be used as the only way to make payment on a house!!!
A 5/1 ARM is a loan which is fixed for five (5) years, then adjusts once annually (1) thus the 5/1. These loans are based on an index, usually the 1 yr Libor or the 1yr Treasury plus a margin usually around 2.25% They have adjustment caps and life cap limits.
Mentioned in the first answer is a loan that adjusts 2 times a year and that is called a 5/25 and was primarily used in subprime mortgages because the index (the 6 month LIBOR) was lower and ther Margins were Higher around 4-5% and this is the loan product when used with a subprime (low Credit score) product and high LTV underwriting that has hurt the industry.
So your 5/1, 3/1, 7/1 are based on the 1 year Indices + margin. Your 2/28, 3/27, and 5/25 are based on the 6 month libor + Margin.
The Hybrid Option Arm listed above is new type of option arm loan, which can be based on any number of indices: the 1 month MTA, 3 month MTA, the COFI, COSI, CODI. These loans have 4 payment types. Typically this loan has a low start rate or minimum payment set by the lender, then the interest only on the index plus a margin (or 15yr amortized or 30 yr amortized) It is worth noting that these loans Usually adjust every month…but the HYBRID has a period of years where the index is fixed and you can predict the rate at which you will negatively amortize for that period of time (if you make the minimum payment only.) These loans as you can tell are much more complicated than the 5/1 ARM.