If you're searching for a home but don't expect to be in it very long, you may end up paying more than you need to if you decide to go with a 30-year fixed mortgage. It's possible to lower your monthly payment if you choose to go with an ARM, such as a 7/1 ARM instead. Additionally, a 7/1 ARM could give you more options in the future.
Often, consumers dismiss this mortgage option before understanding how it works. For some home buyers or refinancers, a 7/1 ARM could be a good option for saving money since it tends to offer low rates and 7 years of fixed payments, 2 years more than the popular 5/1 ARM. So, if you're in the market for a new home, here's why a 7/1 ARM might be worth considering.
What Is A 7/1 ARM?
An adjustable rate mortgage (ARM) generally offers a low fixed interest rate for a set amount of time. After the fixed period expires, the fixed rate can adjust based on the current market landscape.
A 7/1 ARM is an adjustable rate mortgage that carries a fixed interest rate for the first 7 years of the loan term, along with fixed principal and interest payments. After that initial period of the loan, the interest rate will change depending on several factors.
7/1 ARM Basics
There are several different components of a 7/1 ARM that borrowers need to be aware of when assessing their mortgage options.
Again, the initial rate and payment amount is fixed for 7 years. Depending on the ARM and the borrower's rate initially, the future rates and payments can vary drastically. Even if rates are stable, your rates and payments may change significantly throughout the loan term.
Several factors impact 7/1 ARM rates, including the index it's attached to, the margin, interest-rate caps, payment caps, and intervals.
In general, the interest rate and monthly payment of an ARM can change every month, quarter, year, 3 years, or 5 years. The duration between the change in rate is called the adjustment period or interval. For example, with a 7/1 ARM, the introductory period is 7 years, and then once that expires, the rate will adjust annually.
Two parts make up the interest rate on an ARM: the index and the margin. The index is generally the measure of interest rates, and the margin is what the lender will add to that rate. If the index increases, so will the interest rate in most situations. It may make the monthly payment increase as well. Conversely, if the index decreases, your monthly payment may decrease as well.
Keep in mind; not all ARM loans may adjust downward. Therefore, make sure to read the fine print of the loan agreement before moving forward, so you know what to expect.
Lenders may base ARM rates on different indexes. Some of the most common indexes used for annual rates is Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).
Some lenders may use their own cost of funds as an index instead of using other indexes. Before signing a loan agreement, make sure you ask the lender what index they use and provide information about the past performance. This will give you insight into how the rate may adjust if you moved forward with that specific loan.
To determine an interest rate on the ARM, a lender will add several percentage points to the index rate. This is known as the margin. The margin amount will vary from lender to lender, but it’s usually constant over the loan term. When you add the margin to the index, lenders get the fully indexed amount.
For example, let’s say a lender uses an index that is currently 5% and then adds a 2% margin. The fully indexed rate would be 7%.
Usually, lenders determine a borrower’s margin by assessing their credit score. Essentially, the better your credit score, the lower the margin the lender may add. When considering an ARM, make sure to review the index and margin.
Interest Rate, Lifetime and Payment Caps
Interest rate caps put a limit on the rate the interest can increase. These caps come in two versions: periodic adjustment caps and lifetime caps. With a periodic adjustment cap, a limit is placed on the amount a rate can increase or decrease between periods. Also, there is a limit placed on the amount a rate can increase throughout the loan term with a lifetime cap. Most ARM loans must have a lifetime limit, by law.
Additionally, there are caps on payment amounts, which place limits on the amount the monthly payment can increase or decrease over the loan's life.
7/1 ARM Advantages And Disadvantages
Of course, some advantages and disadvantages accompany choosing a 7/1 ARM. To better understand if a 7/1 ARM is right for you, here are the pros and cons you should consider.
There are several advantages of choosing a 7/1 ARM, which include:
- Lower payments during the fixed-rate period: Any ARM loan offers potential savings during the initial fixed-rate period. With a 7/1 ARM, your introductory period is locked in for 7 years before any adjustments are made. This period gives you 7 years of predictable payments at a low interest rate.
- Flexibility: If you think your life may change in the next few years, an ARM loan can be a good idea if you’re likely to sell your home or move. This way, you can enjoy the lower payments before the fixed period ends, and before the less predictable period starts.
- Payment and rate caps: 7/1 ARM loans can have several caps, limiting the size of your payment and the rate increase. Caps can include the amount the rate can adjust between periods as well as overtime.
- The possibility of a payment decrease: Your monthly payment can decrease if the rates fall and drive down the index your rate is attached to.
While there are advantages to a 7/1 ARM, some downsides are worth taking a look at. Some disadvantages include:
- Unpredictability: With ARM loans, borrowers must prepare for a rate increase and their payments to go up after the fixed-interest rate period expires. Even for borrowers who carefully plan, there’s a chance they won’t be able to sell or refinance their home when they want to if the market condition changes. Therefore, this leaves homeowners vulnerable to losing their home if they cannot make payments when the interest rate increases.
- Payment penalty: Some lenders may charge a penalty if you decide to sell or refinance your home loan within a specific timeframe. Therefore, if you plan to sell within a certain amount of time, make sure your lender will not charge you a penalty.
- Complexity: ARMs are complex. They come with complicated rules, fees, and payment structures at times. If a borrower struggles to understand how their ARM works, it could pose a risk to the borrower.
Today’s 7/1 ARM Rates
You can find 7/1 ARM rates with financial institutions or other lenders. If you’re interested in comparing interest rates, you can compare rates here.
Should You Get A 7/1 ARM?
If you’re confident that you can make your monthly payments even if the interest rate reaches the maximum amount, then a 7/1 ARM is worth considering. A 7/1 ARM loan might also be worth considering if you think you’re only going to be in your home for a short amount of time before you sell again. This way, you can capitalize on the lower monthly payments.
On the other hand, if you either feel more comfortable with predictable payments or plan to be in your home for a substantial amount of time, a fixed-rate mortgage might be more up your alley. Either way, it’s wise to talk to a Home Loan Expert at Quicken Loans® who can help you determine the best options for your unique situation. Speaking with an expert can ensure you’re making the best decision suitable for your needs.