Table of contents
- What is an ARM loan (Adjustable Rate Mortgage)?
- What is a 7/6 ARM?
- What is a 7/1 ARM?
- 7-Year ARM Rates vs. 30-year fixed mortgage rates
- 7-Year ARM Rates vs. 15-year fixed mortgage rates
- 7-year mortgages vs. other mortgage types
- Who should consider an ARM?
- 7-year ARM advantages
- 7-year ARM disadvantages
- The math on a 7/6 ARM loan
- How to find the lowest 7-year ARM rate
As the real estate economy continues to evolve, some buyers will seek out mortgage options that stray from the long-term fixed rate structure. The ebb and flow of the housing market continues to present new opportunities for buyers to become homeowners, and when economists predict market average interest rates will continue to rise, buyers looking to apply for a home loan might opt for an adjustable rate mortgage.
An adjustable rate mortgage, or ARM, is a home loan structure that guarantees a fixed interest rate for an established number of years, with periodic adjustments when the fixed rate term ends.
ARMs are usually expressed as two variables, such as “5/6” or “7/6,” with the first number indicating how long the interest rate remains fixed, and the second representing how often it will be adjusted following the fixed rate term. A 5/5 ARM, for example, would start you off with a fixed rate mortgage for the first five years. When that term is up, the interest rate would be readjusted every five years.
The fixed rate period on ARM can range from 1-10 years, depending on your lender and what financing structures they have available. When the fixed term expires, your rate could be adjusted higher or lower than it was previously, depending on the state of the index and margins.
Many buyers are drawn to an ARM for the possibility of saving money. On a 30-year fixed rate mortgage, your interest payments are locked in for the full duration of the loan, no matter how the market changes after you’ve closed. ARM interest rates, on the other hand, are regularly adjusted according to the movement in the index. If this average drops below your initial interest rate, you’ll be paying less in interest on your monthly mortgage bill.
While this sounds like an excellent way to save on a mortgage, it’s important to remember that buyers, lenders and real estate agents have no control over the index and how it develops. Interest rates could suddenly spike when your fixed rate term ends, leaving you with a much heftier mortgage bill. Be sure to speak with multiple lenders for a clear outlook of your specific housing market and if it’s the right time for an adjustable rate mortgage.
In recent years, a popular adjustable rate mortgage option has been a 7/6 ARM. As more lenders move away from LIBOR as a way of standardizing interest rates, 7/6 ARMs have become more widely available. With a 7/6 ARM, you’ll still have a fixed interest rate for the first seven years of the loan. After that term, your rate is readjusted every six months.
These semi-annual rate adjustments are determined along the same factors as a 7/1 ARM. Similar to a 7/1 ARM, the fixed rate period on a 7/6 mortgage typically features a lower interest rate than other fixed rate loans.
A 7/1 ARM refers to an adjustable rate mortgage where the interest rate is fixed for the first seven years of the loan, with annual interest rate adjustments when that term is up. So from years 8-30, your mortgage rate will change.
Typically, lenders will utilize LIBOR rates to come up with an appropriate interest rate for a 7/1 loan. However, as of 2022, the use of LIBOR rates will have ceased entirely as banks transition to a new benchmark interest rate. This change means that 7/1 ARMs will slowly be faded out as a lending option and replaced by other ARM structures, such as 7/6. When deciding which mortgage is right for you, it’s important to remember that 7/1 ARMs will soon be unavailable.
Also structured as a 30-year repayment plan, 7/1 ARMs typically come with a relatively lower interest rate than the market average for fixed rate loans. When the fixed rate period expires, the interest will be recalibrated 23 times, or once per year for the remaining life of the mortgage.
Seven full years of fixed payments provides ample time to build a plan for future investments, while allowing for more financial flexibility leading up to the first rate adjustment. Since these borrowers know exactly when their interest rate will change, the first seven years of the loan can be spent building savings and preparing for the adjusted rate.
Adjustable rate mortgages will typically start out with a lower interest rate than a fixed rate mortgage. As an example, let’s say market average interest rates on a 7/6 ARM sat at 3.01%. A 30-year fixed mortgage in the same month might come with an average interest rate of 3.04%.
That difference might not seem like much, but 0.3% saved on monthly mortgage payments for seven years amounts to thousands of dollars in avoided interest payments.
While the 7/6 ARM will be readjusted to a higher or lower amount, a 30-year fixed mortgage guarantees a set-in-stone interest rate throughout the full term of the loan.
7-year ARMs have the interest advantage over 30-year fixed mortgages, but 15-year fixed rate mortgages are usually even lower. As of April 2021, the market average interest on a 15-year plan was 2.35%, according to Freddie Mac.
However, since the 15-year amortization schedule is on a much shorter timescale, you’ll have to pay off a higher portion of your principal each month. For a more personalized estimation of your monthly mortgage expenses, it’s best to use a mortgage calculator.
7-year ARMs are a popular form of financing, but there are other mortgage opportunities at your disposal. Here’s a look at some other mortgage structures and how they might fit your home buying needs.
- 30-year fixed conforming mortgage
- 15-year fixed conforming mortgage
- 5-year ARM conforming mortgage
- 10-year ARM conforming mortgage
- Jumbo mortgage
- FHA conforming mortgage
- VA conforming mortgage
- Interest only mortgage
If adjustable rate mortgage seem like a great fit for your homebuying goals, you might fall into one of the following categories:
Staying for a few years
Buyers who expect to stay in their new home for a short amount of time might benefit from an ARM. By making timely mortgage payments throughout the fixed rate term of the loan, some buyers chose to sell before that period ends, avoiding rate adjustments that could result in a higher monthly bill.
Expecting interest rates to decrease
If the market indicates a decrease in interest rates at the end of your 7-year term, you could benefit from an ARM by paying less when your rate is adjusted.
If you’re confident that index averages will continue to decrease, opting for a 7-year ARM could save you in interest down the line.
Expect your income to rise
If you expect your income to rise in the next few years, an adjustable rate mortgage may not seem like much of a risk. The extra money coming into your bank account can absorb the additional costs if the index’s average interest rates go up by the end of your fixed rate term.
While you might not want to spend that extra hard-earned income on mortgage interest payments, you won’t be as affected if the economy turns against you. You can never be sure about long-term economic changes, so expecting greater income in the future might provide some additional assurance.
7-year ARMs offer advantages that you won’t get with other financing structures. Here’s a look at some of the benefits an ARM can provide.
- Lower payments during fixed rate term
- Rate change caps
- Potential for smaller payments
Lower payments during fixed rate term
7/6 ARM rates are typically lower than their fixed rate counterparts, at least for the first seven years of the loan. Even though the rate will adjust eventually, your locked-in rate at the beginning of your amortization schedule will have you paying less each month.
Rate change caps
Your mortgage bill might be higher after your 7/6 ARM rate adjusts, but that arrangement doesn’t come with infinite risk. Adjustable rate mortgages typically come with caps that put a limit on how much your interest rate can increase.
These caps also apply to other adjustable rate mortgages and will help prevent a skyrocketing mortgage bill.
- Initial adjustment cap: The terms in your lending agreement in your lending agreement puts a cap on your rate’s increase or decrease when that initial fixed rate period expires.
- Subsequent adjustment cap: On a 7/6 ARM, interest rates are adjusted twice per year. The subsequent adjustment cap limits how much your rate can increase for each of these semi-annual changes.
- Lifetime adjustment cap: On top of the initial and subsequent caps, ARMs usually include a lifetime adjustment cap to keep the interest rate below a certain point for the full duration of the loan. The height of this cap for your specific ARM depends on your lender, but according to ConsumerFinance.gov, the average lifetime adjustment cap is around 5%. This means the interest rate on an ARM could not exceed 5% of the mortgage’s initial rate.
Potential for smaller payments
The major advantage of an adjustable rate mortgage is that you could save money in the long run. Your initial 7/6 ARM rate will likely be lower than a fixed rate option. If market average mortgage rates continue to dip after the fixed rate period expires, your rate could decrease even further, lowering your monthly mortgage payments.
However, this drop depends on the state of the economy and is out of the borrower’s control. Be sure to meet with multiple lenders for a solid grasp on market outlooks to find out if a 7-year ARM is your best home loan option.
Like all forms of financing, ARMs come with their own disadvantages. Here are a few key reasons why a 7-year financing plan won’t work for everyone.
- Prepayment penalties
- More complexity
Opting for an adjustable rate mortgage carries a higher degree of risk because of economic unpredictability. After the fixed rate term, your minimum monthly mortgage payments will depend on market factors that are out of your control. If the index continues to go up, so will your monthly interest on an ARM. When your rate is adjusted, you could be paying thousands more in added interest through no fault of your own.
This could make it difficult to predict your available finances down the line. While the rate change caps but a limit on how far your interest will increase, the rate could spike within that range when your 7-year ARM adjusts. When the rate adjusts, you might have to alter some of your savings or investment goals. This can make ARMs a more volatile lending option than fixed rate mortgages, which guarantee an established interest rate for the full term of the loan.
If you’re planning to sell or refinance within the first few years, you might be obligated to pay a prepayment penalty to your lender. This fee is not required by all lenders, so if you do plan on staying in the home for only a number of years, be sure to choose a financing plan that does not come with this stipulation.
With changing interest rates, market unpredictability and additional stipulations, some borrowers might view adjustable rate mortgages as a complicated lending option.
These mortgages do come with more rules than their fixed rate counterparts, but the right real estate agent and lending partner can cut through the confusion and help you decide if an ARM is your best financing option.
For a better understanding of how you can potentially save with an adjustable rate mortgage, let’s crunch some numbers.
Two buyers are approved for a $200,000 home loan, with one opting for a 30-year fixed rate mortgage and the other choosing a 7/6 ARM. In this scenario, let’s assume the 7/6 ARM interest rate was 2.375% and the 30-year fixed is 3.125%.
Take a look at how much each buyer could possibly pay throughout the first seven years of their loan:
First 7 years of an 7/6 ARM
- Loan amount: $200,000
- 7-year ARM monthly payment: $1,266.21
- Total after 7 years: $106,361
First 7 years of a 30-year fixed rate mortgage
- Loan amount: $200,000
- 30-year fixed monthly payment: $1,342.48
- Total after 7 years: $112,768.32
Clearly, the 7/6 ARM borrower will have a lot more money left over after 7 years. However, it’s important to remember that when the rate adjusts, you could end up paying more in interest than you were previously. With a 30-year loan, however, you’ll have built up more equity in the home when the first seven years are up.
Once you’ve done your research and have found the perfect home loan for your real estate goals, you’re ready to start your mortgage application.
- Sample payment does not include taxes, insurance or assessments. Mortgage Insurance Premium (MIP) is required for all FHA loans and Private Mortgage Insurance (PMI) is required for all conventional loans where the LTV is greater than 80%.
- Mortgage interest rates shown are based on a 60-day rate lock period.
- The displayed Annual Percentage Rate (APR) is a measure of the cost to borrow money expressed as a yearly percentage. For mortgage loans, excluding home equity lines of credit, it includes the interest rate plus other charges or fees (such as mortgage insurance, discount points, and origination fees). For home equity lines, the APR simply reflects the interest rate. When shopping for a mortgage, you can use the APR to compare the costs of similar loans between lenders.
- The estimated total closing costs above do not constitute and are not a substitute for a loan estimate, which includes an estimate of closing costs, than you will receive once you apply for a loan. The amounts provided above for Estimated Total Closing Costs, are estimations based on the state selected. This is NOT a mortgage loan approval or commitment to lend. The actual fees, costs and monthly payment on your specific loan transaction may vary, and may include city, county or other additional fees and costs.
- These mortgage rates are based upon a variety of assumptions and conditions which include a consumer credit score which may be higher or lower than your individual credit score. Your loan's interest rate will depend upon the specific characteristics of your loan transaction and your credit history up to the time of closing.
- For adjustable-rate loans, your monthly principal and interest payment will be fixed for a period of time, and then may change based on annual interest rate adjustments. Before choosing an ARM, you should decide if you can manage the maximum estimated payment if the rate increases. To fully understand minimum and maximum payments, please speak to a mortgage loan expert.