Many homeowners skip over 7-year ARM rates
Most home buyers quickly dismiss adjustable-rate mortgages, such as the 7-year ARM, because they can be risky. You might face higher mortgage payments after the initial rate expires.
But if you sold or refinanced the home before the initial rate expired, you’d never see a rate adjustment. You’d pay only the low intro rate, which is typically much lower than fixed mortgage rates.
A 7-year ARM could create seven years of savings. If you plan to move or refinance within seven years, this loan is worth considering.
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What is a 7-year ARM?
A 7-year ARM has an initial fixed period of seven years. Your rate can’t change during that period.
Typically, ARM rates are lower than 30-year fixed rates during the intro period. Once the fixed introductory rate expires, rates and payments are liable to increase. But if the homeowner sells their home or refinances their loan before the fixed rate expires (in this case, within seven years), they don’t have to worry about rate hikes.
During those first seven years, a homeowner could save thousands of dollars, by making lower monthly payments, when compared to the first seven years of a 30-year fixed rate loan.
But make no mistake: If the homeowner kept the 7-year ARM beyond seven years, its rate would change. Depending on market conditions when the rate changes, the loan could cost a lot more.
A 7-year ARM could be a great choice for home buyers
For many homeowners, seven years will exceed the length of time they keep their house or mortgage.
In its 2022 study on home buyer trends, the National Association of Realtors (NAR) measured how long home buyers keep their homes. NAR found that the median home buyer in 2022 expects to stay in the same home for 12 years. But, in reality, homeowners stay only eight years.
Median home buyers age 41 and younger would exit their 7-year ARM before its first rate adjustment. As a result, these buyers are more likely to save with a 7-year ARM.
Tenure in the new home is even shorter for first-time buyers. Median buyers ages 32 to 41 stay six years; buyers ages 23 to 31 stay only four years.
And this data does not include people who refinanced their mortgage but kept the same home. Including refinances would shorten the tenure of home loans even more.
Who should use a 7-year ARM?
Based on this research from NAR, median home buyers age 41 and younger would exit their 7-year ARM before its first rate adjustment. As a result, these buyers are more likely to save with a 7-year ARM.
On the other hand, median buyers ages 42 and older tend to stay in the home longer than seven years, meaning these buyers would experience a rate fluctuation which could increase mortgage payments.
When should you use a 7/1 ARM?
- If you’re certain you’ll keep the same mortgage loan longer than seven years, you’ll probably do better with a 30-year fixed loan, despite its higher rate
- If there’s a good chance you’ll leave the loan before its first rate fluctuation, a 7-year ARM may be worth the risk
- If you know for sure you’ll be selling the home within three or four years, a 7-year ARM should work well. You might even want a 5-year ARM
Of course, nobody can predict their future plans with 100 percent certainty. But even if your plans change and you don’t move, you wouldn’t be stuck with the 7-year adjustable rate mortgage forever. You could always refinance into a different loan type.
How does an ARM work?
Adjustable-rate mortgages have an initial fixed-rate period, during which your rate and payment cannot change. After that, the interest rate can typically adjust once per year based on wider market rates. Most ARMs have a 30-year term in total with the fixed period lasting five to 10 years.
How 7/1 ARMs work:
- A 7/1 ARM has a total loan term of 30 years with a fixed rate and payment for the first seven years
- After year seven, your rate has the potential to adjust once per year for the remaining 23 years
- As your interest rate changes, so will your monthly mortgage payments
The terms of the loan typically include rate caps that limit the amount your rate can adjust each year and over the life of the loan. Lenders also cap the amount your rate can increase at its first adjustment after the fixed-rate period ends.
Borrowers often have to qualify for an ARM based on the “fully indexed rate,” meaning your lender will check to see that you could afford monthly payments even if your loan hit its maximum interest rate cap. This ensures homeowners won’t be priced out of their mortgage loans if rates rise steeply.
What to consider before choosing a 7/1 ARM
When you’re considering this loan option, there are six factors to consider, according to the Consumer Finance Protection Bureau:
- Initial rate: The interest rate during the initial fixed-rate period. For a 7/1 ARM, the initial period lasts seven years
- Adjustment period: How often the rate changes after the initial fixed-rate period. For a 7/1 ARM, the rate could change once per year after the initial period ends. With a 7/3 ARM, the rate could change every three years after the initial rate expires
- Index rate: This is the market rate on which your ARM rate is based. When your rate adjusts, it will move in tandem with the market index. Older loans use the London Interbank Offered Rate, or LIBOR, as an index rate. A new ARM loan might tie your rate to the Secured Overnight Financing Rate (SOFR), the yield on a 1-year Treasury bill, or the cost of funds index (COFI)
- Margin: The “margin” is the difference between your index rate and your ARM’s actual rate. For instance, if the margin is 2%, your ARM rate will be calculated at each adjustment by adding 2% to the current index rate
- Interest rate caps: These caps limit the amount your rate can increase at its first adjustment; the amount it can increase at each subsequent adjustment; and the total amount it can increase over the life of the loan
- Payment cap: This is a limit on the amount your monthly mortgage payment can increase
The caps and margins built into an ARM help protect the borrower from sudden, drastic rate adjustments. For example, even if interest rates doubled before your first rate adjustment, the initial adjustment cap would limit how much your rate could rise.
Borrowers — especially first-time home buyers — should carefully read their Closing Disclosure to learn about the new loan’s caps and margins. This document will be provided by the mortgage lender at least three business days before closing.
A mortgage calculator can help you anticipate the effects of future higher rates. Keep in mind that your loan amount should be smaller in seven years after the initial rate period of a 7/1 ARM expires.
7/1 ARM rates vs. fixed interest rates
ARM initial rates are generally half a percentage point to a full percentage point lower than 30-year fixed rates. As rates climb higher, the gap between fixed and adjustable rates tends to grow larger.
As current mortgage rates have returned to historic norms in 2022, ARMs have grown more popular.
To see the result of these lower ARM rates, let’s look at an example:
- If you qualify for a fixed rate of 5.75% on a $330,000 home with a 5% down payment, you’d pay $1,829 in principal and interest payments each month
- A 7/1 ARM rate on the same home might be 5%, lowering your monthly principal and interest payments to $1,682
- That’s $147 saved each month using an ARm instead of an FRM
- After seven years, $147 a month totals $12,348 in savings
ARM rates vary by borrower
Just like rates on 30-year fixed-rate mortgages, actual rates for ARMs depend on the borrower.
As a borrower, your credit score, down payment size, loan type, loan amount, and current debt load will affect your ARM’s initial interest rate. The lower your initial rate, the more money you can save on your home purchase.
What if my plans change?
If your plans change and you stay in the home or mortgage longer than seven years, the 7-year ARM still might work, even though it’s less certain than a fixed rate.
An ARM’s lifetime cap acts as a firewall on the loan’s rate. So even in a skyrocketing interest rate market, you’d have at least some protection.
For example, an ARM with a 5% initial rate and a 4% lifetime cap can’t rise above 9 percent. Nobody in the 2020s wants to pay 9% on their primary residence, but without the lifetime cap, the rate could climb into the double digits.
If nothing else, the rate cap could buy some time until you refinance into a fixed rate.
7/1 ARM rates vs. 5/1 ARM rates
Compared to the 7/1 ARM, more loan shoppers choose a 5/1 ARM. This type of mortgage has its initial fixed rate for five years rather than seven, though it still has a total loan term of 30 years. Just like with a 7/1 ARM, your 5/1 ARM rate can adjust once per year after the initial 5-year fixed rate expires.
5/1 ARMs are popular because their initial rate is usually lower than a 7-year ARM’s initial rate.
A 5/1 ARM rate is lower because the intro rate expires two years sooner than a 7/1 ARM’s initial rate. Thus, these loans are less risky for lenders.
7-year ARM FAQ
Yes, FHA loans offer ARMs with 3, 5, 7, and 10-year introductory rates. After the initial rate expires, FHA-insured ARMs will change their rates annually.
Yes, it is possible to find VA-insured loans with adjustable rates. Check with your VA lender to learn its loan options. And VA loans offer an easy way to refinance out of an ARM: the VA IRRRL program.This could help you refinance quickly and cheaply before your initial ARM rate expires.
If you plan to keep the home loan for seven years or less, a 7/1 ARM may be a great idea. These loans can offer low rates compared to a 30-year fixed rate loan. With a lower rate you could build home equity faster. Since you’d be keeping the loan less than seven years, this lower initial rate would not have time to expire.
Yes, mortgage lenders offer adjustable rates on jumbo loans, which home buyers use to finance more expensive real estate. Jumbo loans exceed the loan limits for Fannie Mae and Freddie Mac conventional loans.
Yes, with each rate change, an ARM’s new rate reflects current mortgage rates. Rates can go up or down. For example, someone who opened a 7/1 ARM in 2014 likely got a lower rate seven years later, in 2021, when mortgage and refinance rates were near historic lows.
No. Federal law prohibits prepayment penalties on adjustable-rate mortgages. You can refinance or pay off the loan without penalty. However, refinancing will require paying closing costs again.
What are today’s adjustable loan rates?
Adjustable rate mortgages can make homeownership more affordable. ARM rates are well below fixed rates.
Home buyers who plan to move or sell their home before their ARM’s low rate expires can save a lot of money. How much money? Compare adjustable-rate and fixed-rate preapprovals from a mortgage lender to find out for sure.