7/6 ARM: Definition And How It Works
Kevin Graham5-minute read
May 19, 2022
If you're searching for a home but don't expect to be in it very long, you may end up paying more than you need to if you decide to go with a 30-year fixed-rate mortgage. It's possible to lower your monthly payment if you choose to go with an adjustable-rate mortgage, such as a 7/6 ARM.
Often, consumers dismiss this mortgage option before understanding how it works. For some first-time home buyers or refinancers, a 7/6 ARM could be a good option for saving money since it tends to offer low rates along with 7 years of fixed payments, 2 years more than the popular 5/1 ARM. Additionally, if you move out within the first 7 years, you won't have to worry about an adjustment to your interest rate.
So, if you're in the market for a new home, here's why a 7/6 ARM might be worth considering.
What Is A 7/6 ARM?
A 7/6 ARM is an adjustable-rate loan that carries a fixed interest rate for the first 7 years of the loan term, along with fixed principal and interest payments. After that initial period of the loan, the interest rate will change depending on several factors.
7/6 ARM Loan Basics
There are several basic components of a 7/6 ARM that borrowers need to be aware of when assessing their loan options.
Since the initial interest rate is only fixed for 7 years, the future rates and payments can vary dramatically after the rate adjustment, depending on the ARM and the current market. Even if rates are stable, your monthly payments may change significantly throughout the loan term.
Several factors impact 7/6 ARM rates, including the index it's attached to, the margin, interest rate floors and caps, as well as intervals.
In general, the interest rate and monthly payment of an ARM may change every month, quarter, year, 3 years or 5 years. The duration between the change in rate is called the adjustment period or interval.
For a 7/6 ARM, the introductory period is 7 years, and then once that expires, the interest rate can adjust every 6 months. Keep in mind, not all ARM loans may adjust downward even if market movement would indicate it should do so. That’s why you should make sure to read the fine print of your mortgage agreement before moving forward.
Our loans adjust up or down based on market conditions subject to limitations that we’ll get into below.
Lenders may base ARM rates on various financial market indexes. Some of the most common indexes used for ARMs are Treasury (CMT) securities, the Cost of Funds Index (COFI) and the Secured Overnight Financing Rate (SOFR).
Starting in 2022, the London Interbank Offered Rate (LIBOR) will phase out and no longer be used for benchmarking interest rates. If you have an ARM, it’s going to affect your interest rate compared to other types of home loans since non-fixed-rate loans are often tied to the LIBOR benchmark.
To determine an interest rate on an ARM, a base percentage is added to the index rate to cover the cost of lending the money. This addition is known as the margin.
Lenders may determine a borrower’s margin based on a flat percentage or by assessing their credit score. Under this model, the better your credit score, the lower the margin you’ll qualify for. Your rate will never be lower than the margin. When considering an ARM, make sure to review the index and margin.
Interest Rate Caps And Floors
Interest rate caps put a limit on how much the interest rate can increase. Usually, these come with a corresponding floor that limits how much your payment can move downward as well. These caps and floors come in three versions: initial, periodic adjustment caps and lifetime caps.
With an initial adjustment cap and floor, a limit is placed on the amount a rate can increase or decrease at the initial adjustment. There are also limits to how much your rate can go up or down with each subsequent adjustment. Finally, there is a limit placed on the amount a rate can increase or decrease throughout the loan term with a lifetime cap. Most ARM loans must have a lifetime limit by law.
When ARMs are advertised, you’ll see products advertised like this: 7/6 ARM 5/1/5. The first number refers to how long the rate stays fixed at the beginning of the loan, in this case 7 years. The second number is how often the rate adjusts after the fixed period – every 6 months.
The last three numbers listed are the caps and floors. In this case, your rate won’t go up or down more than 5% on the initial adjustment. The rate can’t increase or decrease more than 1% with each adjustment after the first. Finally, your rate won’t rise or fall more than 5% over the life of the loan. Make sure you know all of your interest and payment caps when considering an ARM.
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7-Year ARM FAQs
Of course, a 7/6 ARM comes with some advantages and disadvantages. To better understand if a 7/6 ARM is right for you, here are some common questions you should consider.
What are the advantages of a 7/6 ARM?
There are several reasons to choose a 7/6 ARM, including:
- Lower payments during the fixed-rate period: Any ARM loan offers potential savings during the initial fixed-rate period compared to a standard fixed-rate loan. With a 7/6 ARM, your introductory period is locked in for 7 years before any adjustments are made. This period gives you 7 years of predictable payments at a low interest rate.
- Flexibility: If you think your life may change in the next few years, an ARM loan can be a great idea and a way to save money.
- Interest rate caps: 7/6 ARM loans can have several caps, limiting interest rate increases. Caps can include limits on how much the rate can go up between periods as well as the maximum interest rate change.
What are the disadvantages of a 7/6 ARM?
While there are advantages to a 7/6 ARM, some downsides are worth taking a look at. The disadvantages include:
- Unpredictability: With ARM loans, borrowers must prepare for rates and their mortgage payments to change after the fixed interest period expires. Even for borrowers who carefully plan, mortgage payment changes can be a shock. Therefore, this leaves homeowners vulnerable to financial stress if interest rates increase.
- Payment penalty: Some lenders may charge a penalty if you decide to sell or refinance your home loan within a specific timeframe. Therefore, if you plan to sell within a certain amount of time, make sure your lender will not charge you a penalty. Rocket Mortgage® never changes prepayment penalties.
- Complexity: ARMs are complex. They sometimes come with complicated rules, fees and payment structures. If a borrower struggles to understand how their ARM works, it could pose a financial risk to the borrower.
- Shorter fixed-rate period: While 7 years might seem like a long amount of time, some borrowers may appreciate a bigger fixed-rate period. 10-year ARMs can give home buyers an extra 3 years of steady monthly payments that a 7/6 ARM can’t offer.
- Limits on interest rate decreases: Your interest rate can’t go up beyond the cap. However, there are also corresponding floors to how much your rate can decrease. Your rate will also never go down below the margin set by your lender.
The Bottom Line: Should You Get A 7/6 ARM?
If you’re confident that you can make your monthly payments even if the interest rate reaches the maximum amount, then a 7/6 ARM is worth considering. A 7/6 ARM loan might also be worth the risk if you think you’re only going to be in your home for a short period of time before you sell again. This way, you can capitalize on the lower monthly payments.
Are you ready to move forward with an adjustable-rate mortgage? Get preapproved today with Rocket Mortgage. You can also give us a call at (833) 326-6018.
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