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About 8 percent of U.S. households have adjustable-rate mortgages. One of the most popular types is the 7/1 ARM, which may be a good fit for borrowers who plan to stay in their home for just a few more years or who expect their interest rate to decrease over time.
What is 7/1 ARM?
A 7/1 adjustable rate mortgage (ARM) starts out with a fixed interest rate for the first seven years, with the interest rate adjusting annually thereafter.
This mortgage combines the features of both a fixed-rate mortgage and an adjustable-rate mortgage. Its biggest attraction is that it has a lower starting interest rate than a fixed-rate mortgage, which means lower initial monthly payments.
After the fixed-rate period ends, your interest rate may fluctuate up or down depending on market conditions. This flexibility is a double-edged sword: if interest rates fall, your payments may go down, but if interest rates rise, your payments may go up. This potential for fluctuation makes the 7/1 ARM an attractive option for people who plan to sell their home or refinance into a fixed-rate mortgage within the first seven years.
How does the 7/1 ARM work?
If you take out a 7/1 adjustable rate mortgage on April 1, 2023, your first interest rate adjustment will be on April 1, 2030, seven years after your loan is paid off.
When the interest rate on an ARM adjusts, the new interest rate is usually based on a benchmark or index plus a few percentage points (called a margin.) Your loan documents will state the index and margin used.
Two indexes commonly used for ARMs are the 11th District Cost of Funds Index (COFI) and the Secured Overnight Funding Rate (SOFR).
Your loan documents also typically state the minimum and maximum interest rates, as well as the cap on how much your interest rate can adjust at any one time, which can help reduce the shock when your interest rate resets for the first time after your initial seven-year fixed-rate period.
7/1 ARM Example
For example, let’s say you’re buying a $400,000 home, putting 20 percent down and financing the balance with a 7/1 ARM for $320,000. Your initial interest rate is 6 percent, the minimum interest rate is 5 percent, the maximum interest rate is 10 percent, and the maximum change per adjustment is 2 percent.
Your first payment is $1,918.56. After seven years, your interest rate (and payments) will change every year until you pay off your loan. If interest rates were rising when the first adjustment period comes around, your loan interest rate could increase by up to 8 percent. Conversely, if interest rates were falling, your interest rate could decrease by 1 percent to 5 percent. After a year, your interest rate could increase again by up to 2 percent or decrease by 2 percent. In this scenario, your maximum monthly payment would be $2,625.68.
Assume interest rates increase by 1 percent each year. Your payments will be:
| Payment Number | interest rate | Monthly payment |
|---|---|---|
| 1 | 6% | $1,918.56 |
| 84 | 7% | $2,093.75 |
| 96 | 8% | $2,270.48 |
| 108 | 9% | $2,448.02 |
| 120 | 10% | $2,625.68 |
| 132 | 10% | $2,625.68 |
Remember that your monthly payment includes all interest accrued since your last payment, as well as a portion of the principal. This means that if the interest rate on your loan increases, your monthly loan payment will also increase. You can use an ARM calculator to figure out how your payments will change over time.
Pros and Cons of 7/1 Adjustable Rate Mortgages
7/1 Advantages of ARM
- The first is cheap: The interest rate on a 7/1 ARM can be as much as a percentage point lower than a 30-year fixed mortgage, and a lower interest rate means a lower monthly payment.
- You might even pay less: If interest rates are falling, your monthly payments will also decrease after the initial period and may also decrease at future resets.
7/1 Disadvantages of ARM
- Rising interest rates can increase your costs: Long-term interest rates are harder to predict. Once the fixed introductory period ends, interest rates may rise or fall. If interest rates rise, your payments will increase.
- complicated: Adjustable rate mortgages have more variables than fixed rate mortgages: interest rate caps, interest rate indexes, resets, etc. These can get pretty technical for the average homeowner.
- The Interest-Only Trap: With some ARMs, called “interest-only” ARMs, during the initial fixed-rate period, your first payment goes only toward the interest on your loan, not toward the principal. This can help you stretch your budget and lower your payments, but after the fixed period, your payments increase significantly to include the principal. If home prices fall, you may have difficulty paying off your loan.
- Difficulties in budgeting: A mortgage is often a household’s largest monthly expense, and when interest rates start to fluctuate, it can become difficult to budget for a mortgage.
7/1 ARM Qualification
Like any mortgage, ARMs have strict qualification requirements. You’re taking out a large, long-term loan, and lenders want to be sure you’ll pay off the loan. In particular, they need the following:
- At least a “fair” credit score, i.e. 620
- Your debt-to-income ratio (DTI) should ideally be below 36% (some lenders will go as high as 43%)
- At least 3% down payment
In some ways, ARMs may be easier to qualify for than other loans. A lower initial interest rate means you’ll have a lower payment, so you can keep your debt-to-income ratio lower than with a fixed-rate loan that has a higher interest rate. Keep in mind that mortgage interest rates may rise in the future, which could tighten your budget down the road.
In fact, lenders know this and will consider a borrower’s ability to handle rising interest rates when reviewing a loan, so they may look especially closely at the stability of a borrower’s total income (and its potential for increase) and want to keep their DTI low.
Current 7/1 ARM Rates
Interest rates on 7/1 ARM loans, like all mortgage types, are constantly changing. According to Bankrate’s survey of national lenders, the average interest rate for a 7/1 ARM was 6.28% on Friday, August 16, 2024. By comparison, the national average interest rate for a 30-year fixed-rate mortgage was 6.56% on the same date. These rates and APRs are based on a FICO credit score of 740 and an owner-occupied single-family home.
Other adjustable rate mortgages
The 7/1 ARM is just one type of ARM. Lenders offer many other adjustable rate mortgages with a variety of interest rate fixes and adjustment periods. Other common options include:
10/1 ARM – These loans have a fixed interest rate for 10 years that adjusts annually after that. They are a good choice for those who plan to stay in their home for more than 10 years.
5/6 ARM – A 5⁄6 ARM loan has a fixed interest rate for five years, then adjusts semi-annually after that. It can be a good choice for those who think interest rates will fall or who don’t plan on staying in their home long term.
3/1 ARM – This loan has a fixed interest rate for a minimum of 3 years, with annual adjustments thereafter. It is popular for those who plan to sell their home within a few years and want the lowest possible payment. It is also a popular option for those who expect interest rates to drop within the next 3 years and plan to refinance.
These are just a few examples of popular ARMs: Lenders are free to offer a variety of terms, such as a 15-year interest rate lock-in period or allowing borrowers to choose their own payment structure and schedule.
How to compare ARM
Here are some important details to look out for when buying an ARM:
- Fixed interest rate period: This is the first number in the ARM’s name. The shorter the term, the lower the initial interest rate will usually be. However, the longer the adjustable rate period, the greater the risk if interest rates rise. Common fixed rate terms are 3, 5, and 7 years.
- Adjustment interval: This is the second number in the ARM’s name. It is how often your interest rate will change after the fixed-rate period ends. The number “1”, which signifies an annual change, is the most common number you’ll see here.
- Teaser Price: The initial interest rate offered for the fixed interest period.
- Initial Cap: This limits the range, in percentage points, by which your interest rate will adjust immediately after the end of your fixed-rate period.
- Regular Rate Cap: This is the maximum amount by which your rate can change on each adjustment date, and may or may not be the same as your initial cap.
- Lifetime Cap: This limits how much your interest rate can increase over the life of your loan.
- Payout Limit: This limits the amount your monthly payments can increase over the life of your loan.
- Minimum and maximum rates: These are the minimum and maximum interest rates to which your loan interest rate can adjust.
- Minimum and maximum monthly payments: Your in and out payment limits, so you know how high or low your payments will be.
7/1 ARM FAQ
Additional reporting by Ashley Tilford
