When shopping for a mortgage, it’s common to look for fixed-rate loans. However, adjustable rate mortgages (ARMs) may offer lower interest rates — because the rate will adjust after the initial fixed period.
Some ARMs are hybrids, offering a lower fixed rate for a set period of time. The 7/1 ARM is one of these types of mortgages, providing you with a lower fixed rate for the first seven years of the term and making it an attractive option for homebuyers.
What is a 7/1 ARM loan?
An adjustable-rate mortgage, or ARM, is a home loan where the interest rate has the potential to change over time. A hybrid, like the 7/1 ARM includes characteristics of a fixed-rate mortgage and an ARM.
Here’s what the two numbers indicate:
- The first number: The number of years in which your interest rate remains fixed.
- The second number: How often the rate will adjust annually after that fixed period.
For example, if you had a 7/1 ARM with a 30-year term, you’d have a fixed mortgage interest rate for the first seven years. After that, you’ll see your rate and payment change once a year for the remaining 23 years.
Learn More: What Is a Mortgage Rate and How Do They Work?
How a 7/1 ARM works
Because ARMs adjust over time, you could end up with a lower or higher monthly payment, depending on whether rates are rising or falling. Your payment changes to ensure that your mortgage is paid off on time.
With a 7/1 ARM, this situation arises after the initial fixed-rate period of seven years. There are usually caps on how much a rate can adjust and other considerations to consider as you choose your mortgage.
Here’s a closer look at how 7/1 ARMs work:
Changing rates
Adjustable rates are determined by an index, which represents a market rate, and the margin that’s added to the market rate. Each year after your fixed-rate period, the lender will review market rates, add the margin to the index, and adjust your payment.
Here’s a quick breakdown of how the index and margin make up your rate:
- Index: Current market conditions are usually expressed using an index. In the past, it was common for mortgage lenders to use the London Interbank Offered Rate (LIBOR). However, LIBOR was phased out as of June 30, 2023, and many U.S. lenders now use the Secured Overnight Financing Rate (SOFR). Other indexes that could be used include the Constant Maturity Treasuries (CMT) and the Cost of Funds Index (COFI).
- Margin: Your lender adds a fixed percentage on top of the index rate to get your new interest rate. For example, if you have a margin of 6.5% and your rate adjusts based on the SOFR — and the SOFR is at 0.15% — your new mortgage rate would be 6.65%.
Tip:
Ask your lender to find out which index it uses, along with the margin it adds to the index.
Read More: 10/1 ARM: Your Guide to 10-Year Adjustable-Rate Mortgages
Interest rate caps
Even though your mortgage rate adjusts regularly with a 7/1 ARM, following the initial fixed period, there are caps on how high the rate can go.
It’s common for caps to be based on a first adjustment, subsequent adjustments, and a lifetime cap. One common cap is the 2/2/5 cap. Here’s how this cap structure works:
- Initial adjustment cap: The first number indicates the initial adjustment cap. This is the first time the lender adjusts the rate after the end of the fixed term. In the case of the 2/2/5 cap, the rate can’t be more than two percentage points higher than your initial rate, no matter how much interest rates have increased since you got your loan.
- Subsequent adjustment cap: The second number represents the cap on the following adjustments. Once again, in this case, the adjustment can’t be higher than two percentage points over the previous rate.
- Lifetime cap: The final number reflects the lifetime cap. If you have a 2/2/5 cap, the interest rate can’t go five percentage points beyond your initial rate.
Loan terms
When getting a mortgage, understand that 7/1 ARM loans usually have an overall term of 15 years or 30 years. The interest rate remains fixed for the first seven years, then adjusts every year after that for the rest of the loan term.
A home loan calculator can help you determine what your payment might look like at a certain interest rate.
To get a better idea of what you’d pay each month (in principal and interest only) with a 7/1 ARM vs. a fixed-rate mortgage, let’s review a quick example.
Example: Say you’re looking to take out a $250,000 mortgage, and you have to choose between a 30-year fixed-rate loan at 3.65% APR and a 7/1 ARM with an initial APR of 2.85%.
- With the fixed-rate loan, your monthly payment would be $1,144 and you’d end up paying $161,714 in interest over the life of the loan.
- With the 7/1 ARM, your monthly payment for the first seven years would be about $1,034. Assuming your loan follows the 2/2/5 cap structure, the highest amount you’d end up paying each month after the initial period would work out to approximately $1,592. Depending on the adjustments, you could end up paying over $262,000 in interest.
Pros and cons of a 7/1 ARM
A 7/1 ARM can make homebuying more affordable for you given its low initial rate. You’ll start with a lower payment, and you could save money if you refinance before the initial seven-year fixed period is up.
However, should you decide to keep the loan, you’ll need to be comfortable with the idea of your monthly payment possibly going up. Plus, if rates continue to rise, you might end up paying more in interest over the long haul.
Pros
- Lower interest rate at first: A lower initial rate means a lower mortgage payment during the first seven years of your loan. You may choose to invest the difference, pay down the principal, or make improvements to the house.
- Could pay less in interest: If rates remain low (or even drop), you could potentially save on overall interest. On top of that, if you take the difference in your monthly payment versus a fixed-rate mortgage and put it toward the principal, you might reduce the balance you’re paying interest on, saving you even more money.
- Beneficial if you’ll move soon: If you know you’ll move within seven years, you could save by selling the house before the rate adjusts. You can save on monthly cash flow and interest until you move again.
Learn More: ARM vs. Fixed Mortgage: How to Choose Between Them
Cons
- Mortgage payment could increase: If rates go up after the initial seven-year fixed period, so will your mortgage payment. Even with a cap, these higher rates could have a significant impact on your budget.
- Interest could be more expensive over the loan term: You could end up paying more in interest — even with caps in place — if mortgage rates continue to rise over time.
- Rate difference might not be worth the hassle: Sometimes, there isn’t much difference between the interest rate of a fixed-rate loan and a 7/1 ARM. As a result, choosing a slightly higher initial payment with a fixed-rate loan might be the better option in the long run. Especially since refinancing your mortgage comes with additional costs if you decide to switch to a fixed-rate loan later.
When to consider a 7/1 ARM
A 7/1 ARM is a good option if you intend to live in your new house for less than seven years or plan to refinance your home within the same timeframe.
An ARM tends to have lower initial rates than a fixed-rate loan, so you can take advantage of the lower payment for the introductory period.
If you sell the home before that seven-year period expires, you won’t have to worry about market fluctuations or changes to the interest rate and monthly payment.
You can also refinance before the end of the period, but there are usually refinancing closing costs that can add to the overall cost of your mortgage.
