These loans disappeared early in the recession. Now they’re back.
What is a 7/1 ARM?
A 7/1 ARM is an adjustable-rate mortgage that carries a fixed interest rate for the first seven years of its term, along with fixed principal and interest payments. After that initial period of the loan, the interest rate will change depending on several factors. A 7/1 ARM might be attractive to borrowers over a fixed-rate mortgage because they’ll pay lower interest in the initial period.
Adjustable-rate mortgages (ARMs) allow borrowers to pay lower interest rates on their loan for a set period, after which the rates get changed. The 7/1 ARM means that for seven years the borrower’s interest rate will remain fixed. That’s a clear advantage the 7/1 ARM has over other ARMs with shorter fixed-rate periods.
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However, they also run the risk of potentially higher mortgage payments at the end of the seven years. Whether the rates increase or decrease is determined by
- Indexes: ARMs are tied to an index of interest rates like the London Interbank Offered Rate (Libor).
- Margins: 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.
In years when interest rates are low, ARMs are less popular than fixed-rate mortgages. When the opposite is true, borrowers prefer to risk a higher rate in the future in exchange for reduced interest payments now.
7/1 ARM example
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.