What is a 7/1 adjustable-rate mortgage (ARM)?
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What is a 7/1 ARM?
A 7/1 ARM is a mortgage that has a fixed interest rate in the beginning, then switches to an adjustable or variable one. The 7 in 7/1 indicates the initial fixed period of seven years. After that, the interest rate adjusts once yearly based on the index stated in the loan agreement, plus a margin set by the lender. The 7/6 ARM is another common mortgage, which adjusts every six months after the initial period.
When does a 7/1 ARM adjust?
If you were to close your loan on July 1, 2022, the first rate adjustment will happen on July 1, 2029 — that is, seven years later.
At this time, the payments of your loan are recalculated going forward based on the new interest rate. The new rate could be higher or lower than the initial rate. Then, a year later on that same date, the loan’s rate will reset again, and so on each year throughout the term of the loan.
ARMs generally come with a cap on how much the interest rate can rise over the loan period and at each reset.
What index does the 7/1 ARM use?
An index is a published value that is frequently updated to reflect the current rate. For years, these ARM loans have been tied to the yield on 1-year Treasury bills, the 11th District cost of funds index (COFI) or the London Interbank Offered Rate (LIBOR). As of this year, LIBOR has been discontinued and replaced by a new index called the Secured Overnight Financing Rate (SOFR).
The mortgage rate is determined by the rate of the index plus a stated margin. For example, in May 2022, SOFR reached 0.80 percent. A typical spread on SOFR ARMs is 2.75 percent. In this case, the loan rate would be the sum of the two, or 3.55 percent.
7/1 ARM vs. 5/1 ARM
The 5/1 ARM has the same features of the 7/1, but the initial rate adjusts after the first five years. Generally, the interest rate on the 7/1 will be a little higher than the 5/1, reflecting the added time the initial rate is locked in.
7/1 ARM vs. 3/1 ARM
Here again, the 7/1 ARM mirrors the 3/1 ARM, with the initial rate resetting after the first three years. The initial interest rate will be lower than the 7/1 because there’s less risk for the lender.
What are the pros and cons of a 7/1 ARM?
- Cheaper at first: The main benefit of a 7/1 ARM is lower monthly payments compared with a 30-year fixed mortgage. Interest rates for ARMs in recent months have dipped a full percentage point below comparable 30-year fixed loans.
- The payments might get even cheaper: If interest rates are falling, then your monthly payment will also decline after the initial period and potentially during future resets.
- Rising rates could cost you more: The big minus of the 7/1 ARM is exposure to higher rates after the fixed period is up. If rates have risen, your payment will increase.
- Complexity: There’s more moving parts to an adjustable mortgage than a fixed one. Rate caps, indexes, resets — this can be pretty technical stuff for the average homeowner.
- Interest-only trap: With some ARMs, known as “interest-only” ARMs, your initial payments go toward only the loan interest and not principal in the initial fixed-rate period. That can allow you to stretch your budget and lower your payment, but after the fixed period your payments will be much higher to include the principal. If home values drop, you could find yourself underwater on the loan.
Correction, Feb. 10, 2023, 3:30 pm ET: A previous version of this article incorrectly stated that the SOFR was 1.05 percent in May 2022. This article has been corrected to say that SOFR was 0.80 percent in May 2022.