In years when interest rates are extremely low, adjustable-rate mortgages, or ARMs, are less popular than fixed-rate mortgages. The Mortgage Bankers Association, or MBA, surveys of mortgage applications in 2010 showed that ARMs were chosen by less than 10 percent of borrowers. However, a 7/1 ARM can be a good choice for some homeowners.
What is a 7/1 ARM?
A 7/1 ARM carries a fixed interest rate for the first seven years of the loan, along with fixed principal and interest payments. After the initial term of the loan, the interest rate can adjust according to three factors:
Index. ARMs are tied to an index of interest rates such as the Libor, or the London Interbank Offered Rate.
Margin. The margin, established at the time of the loan approval, remains fixed for the entire loan. For example, a margin could be set at 3 percent, meaning the interest rate charged could be as much as 3 percent higher than the index.
Caps. ARMs usually have a lifetime cap that establishes a maximum interest rate and a periodic cap that sets a limit to the amount the interest rate can change in any one adjustment period.
For example, say a borrower pays an interest rate of 4 percent during the first seven years of a 7/1 ARM. After seven years, if the index is 6 percent and the margin is 3 percent, the interest rate becomes 9 percent. However, if the loan has a lifetime cap of 4 percentage points, then the maximum interest rate would be 8 percent.
Advantages of a 7/1 ARM
While ARMs are sometimes considered risky because of the possibility of increased mortgage payments, a 7/1 ARM has the advantage of a fixed rate for a longer period than some other ARMs. The main reason to choose an ARM is that it usually has a lower interest rate in the initial period of the loan than fixed rate mortgages and therefore more affordable payments. For borrowers having a hard time qualifying for a mortgage, the lower payments could mean the loan will be approved.
Disadvantages of a 7/1 ARM
The major disadvantage of an ARM is the possibility of an increase in the interest rate that will make the payments unaffordable. ARM borrowers should ask their lender for an estimate of the highest possible monthly payment with their individual loan terms to see if they would be able to make the mortgage payments if they were unable to sell the home or refinance when the loan adjusts.
Is this mortgage loan right for you?
When interest rates are higher, many borrowers opt for a 7/1 ARM in order to have reduced interest payments during the initial loan period. Borrowers who are certain they will sell their home or have a higher income before the loan resets are the most likely to choose an ARM.