Fixed-rate mortgages finance the majority of homes across the country, allowing homeowners to make unchanging monthly payments until they repay the loan. However, fixed-rate mortgages can have expensive interest rates. While adjustable-rate mortgages (ARM) can have volatile interest rates, hybrid products like the 7/1 adjustable rate mortgage give homeowners a combination of stability and decreased interest rates. A 7/1 ARM can provide homeowners with savings on monthly payments because of an initially low-interest rate and a yearly rate adjustment afterward.
You can work with a financial advisor to determine if it’s the right mortgage choice for your financial situation.
What Is a 7/1 Adjustable Rate Mortgage (ARM)?
A 7/1 adjustable-rate mortgage (ARM) is a mortgage that gives homeowners an initial low-interest rate. The first number in the name (7) refers to the seven years in which the loan maintains a small interest rate. Following the seven-year period, the rate adjusts once a year based on market index rates, hence the 7/1 name.
For example, if you have a 7/1 ARM for a 20-year mortgage, you would receive a promotional interest rate for seven years. However, when the seven years expire, your loan would adjust thirteen times over the remaining thirteen years of the mortgage.
Fortunately, although your interest rate may adjust over a dozen times, cap structures keep your interest rate from spiraling out of control. For example, a 3/2/4 cap structure’s three figures would limit your interest rate in the following ways:
- The initial adjustment cap in the example is three. This means the first adjustment following the seven years cannot exceed three percentage points above the initial interest rate.
- The subsequent adjustment cap, which is two in this example, means that further adjustments cannot be more than two points higher than the last rate.
- The lifetime cap is four, meaning that your interest rate will not rise above four points from the initial rate.
What Index Does a 7/1 Adjustable Rate Mortgage (ARM) Follow?
Banks have multiple indexes they use to adjust interest rates for 7/1 ARMs. These indexes change over time, and your interest rate will follow the trend in its corresponding index. Your ARM might follow the rates of the 11th District Cost of Funds Index (COFI), 1-year Treasury bills or the Secured Overnight Financing Rate (SOFR). After your interest rate adjusts every year, your lender adds an amount called a margin to the interest rate, which they take as income for their services.
For example, let’s say your ARM follows the COFI, which has an interest rate of 1.283%. Your lender will add the COFI rate to their margin of 2.5%, giving you a final rate of 3.783%. However, if your ARM loan terms significantly cap your interest rate, it could be lower.
Advantages of Using a 7/1 ARM
Compared to similar mortgage products, the 7/1 ARM balances the timeframe for a decreased interest rate, giving many borrowers plenty of time to refinance, sell the property or prepare for larger payments. Borrowers who use a 7/1 ARM will reap the following benefits:
- Inexpensive Monthly Payments, Initially: You’ll have a small mortgage payment during the initial period compared to fixed-rate loans. As a result, you could accumulate considerable savings over the first seven years of your mortgage. You could also apply your savings to the loan principal, saving even more in the long run.
- Continuing Favorable Interest Rate: Your interest rate could stay low after your first adjustment, furthering your savings. As long as the index for your ARM maintains a low-interest rate, you won’t experience a rate hike.
- Benefit From Selling or Refinancing: If you plan on selling the house before the seven years expires, you could enjoy the low-interest rate and get out of the house before the first adjustment. Similarly, refinancing before seven years is up can give you access to a fixed rate mortgage on the same home.
- Freedom With Savings: You’re free to use the savings from a 7/1 ARM however you wish, from renovations to putting more money into your IRA to saving for a vacation.
Disadvantages of Using a 7/1 ARM
As with any financial product, you have pros and cons to consider. Borrowers with a 7/1 ARM might experience challenges, including:
- Increased Interest: After seven years, your interest rate could jump, causing financial strain. Although your ARM will have a cap in place, a rate that increases by the maximum amount allowed could jeopardize your ability to pay your mortgage. Therefore, it’s recommended to calculate if you can afford the payment with the maximum allowed interest rate before choosing a 7/1 ARM.
- Interest Payment Lock: Your ARM might only allow you to pay the interest for the first seven years. All the while, the principal would sit untouched, and you would have to wait for your first adjustment to start hitting the principal. As a result, your monthly payment might increase drastically after seven years. Additionally, after seven years, your home value could drop beneath the principal owed, meaning you would have an underwater mortgage.
- Density in the Details: 7/1 ARMs are intricate loan products. As such, they can be difficult for homeowners to understand. It’s a good idea only to take on a 7/1 ARM if you understand the ins and outs.
- Insignificant Savings: Depending on your interest rate, a 7/1 ARM might not be worth the trouble. A fixed-rate mortgage with only a slight difference in interest from a 7/1 ARM is likely worth taking. The slight savings for the first seven years will likely vanish after the first adjustment. Plus, fixed-rate mortgages are more straightforward, and your monthly payment won’t change throughout the life of the loan.
Is a 7/1 ARM Right for You?
A 7/1 ARM could provide you with significant savings. The reduced mortgage payment may free up hundreds of dollars monthly, allowing you to save more for retirement or start a college fund for your child. In addition, if you’re planning on moving or refinancing before seven years is up, you can take advantage of the low-interest rate, pay off the loan with the home sale and never have to deal with rate adjustments.
However, if you’re planning on staying in your home for more than seven years, your interest rate might skyrocket and make your mortgage payments unaffordable. A fixed-rate mortgage will give you the same monthly payment for the life of the loan, giving you stability and possibly a lower interest rate over the decades you’ll spend paying your mortgage.
7/1 ARM vs. 5/1 ARM
A 5/1 ARM operates identically to a 7/1 ARM, except the first adjustment occurs after five years instead of seven. As a result, a 5/1 ARM’s interest rate is usually lower because it gives the borrower less time with the initial low rate. The right choice for you, assuming you know that an adjustable-rate mortgage is the right choice, will depend on how long you expect to need the lower payments.
7/1 ARM vs. 10/1 ARM
Similarly, what separates a 10/1 ARM from a 7/1 ARM is how long it takes for the first adjustment. Since a 10/1 ARM does not adjust the rate for ten years, it typically has a higher interest rate than the 7/1 ARM. Those wanting a decent rate for longer than seven years might find the 10/1 ARM as the better mortgage choice.
The Bottom Line
A 7/1 ARM can be an effective financial tool in the right circumstances. With an initially low-interest rate, your ARM could provide you with low mortgage payments for seven consecutive years. Also, if you know you won’t be in your home for more than seven years, you can sell your house and not worry about rate adjustments. However, 7/1 ARMs come with a host of details, such as cap structure and interest-only payment restrictions. Some homeowners might not want to deal with the aggravation of parsing out loan stipulations. Plus, they might want to stay in their home for decades. In those circumstances, a fixed-rate mortgage might make more sense.
Tips for Mortgages
- Purchasing a home is one of the most crucial investments you’ll ever make, and how you finance your house can have significant financial ramifications. Therefore, guidance from a qualified financial advisor can be essential for you and your family during this process. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re stuck between choosing different mortgages, your interest rate might be the deciding factor. Use a mortgage calculator to see how much you can afford.
- House hunting starts with a mortgage preapproval, no matter what mortgage you choose. Preapproval requires extensive documentation and research. So, it always pays to have a mortgage preapproval checklist by your side.
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