7/1 ARM vs. 30-Year Fixed Mortgage: Pros and Cons

June 6, 2011 No Comments »
7/1 ARM vs. 30-Year Fixed Mortgage: Pros and Cons

When shopping for a mortgage, it’s very important to pick a suitable loan product for your unique situation. Today, we’ll compare two popular loan programs, the “30-year fixed mortgage vs. the 7-year ARM.”

We all know about the traditional 30-year fixed – it’s a 30-year loan with an interest rate that never adjusts. Pretty simple, right?

But what about the 7-year ARM, or more specifically, the 7/1 ARM? It’s an adjustable-rate mortgage and a fixed-rate mortgage, all in one. Sounds a little bit more complicated…

Let’s break it down. During the first seven years, the mortgage rate is fixed, meaning it won’t change. And for the remaining 23 years, the rate is adjustable, and can change once per year.  That’s where the number 1 comes in.

This makes the 7-year ARM a so-called “hybrid” adjustable-rate mortgage, which is actually good news. You get the best of both worlds.

It also affords you two additional years of fixed payments when compared to the 5/1 ARM. And those might come in handy…

Why Choose the 7/1 ARM?

7-year ARM

You probably don’t want your mortgage rate (and mortgage payment) to change all the time, especially if it only moves higher.

With the 7/1 ARM, you get mortgage rate stability for a full seven years before even having to worry about the first rate adjustment. And because most homeowners either sell or refinance before that time, it could prove to be a good choice for those looking for a discount.

That’s right, 7/1 ARM mortgage rates are cheaper than the 30-year fixed, or at least they should be. By cheaper, I mean it comes with a lower interest rate than the 30-year fixed, which equates to a lower monthly mortgage payment for the first 84 months!

At the time of this writing, mortgage rates on the 7-year ARM averaged 3.64 percent, according to figures from Bankrate. Meanwhile, the average rate on a 30-year fixed was 4.69 percent.

[What mortgage rate can I expect?]

That’s a difference in rate of more than a percentage point, and a difference in payment of $122.28 a month, $1,467 a year, and over $10,000 over the first seven years on a $200,000 loan amount. Not bad, eh?

Loan amount: $200,000
30-year fixed monthly payment: $1,036.07
7-year ARM monthly payment: $913.79

So not only do you save long-term, but you also save monthly, meaning you can put that extra money to good use somewhere else, such as in a more liquid investment, or simply set it aside to pay other bills.

Is the Lower 7/1 ARM Rate Worth the Risk?

If you actually plan on staying in your home and paying off your mortgage, you face the possibility of an interest rate reset (higher, or lower).

And you don’t want to get caught out if rates surge over the next seven years, especially if you can’t sell your home or don’t want to.

However, if you’re like many Americans, who sells or refinances within seven years, the loan program could make a lot of sense.

Just be sure to do the math on both scenarios before committing to either of these loan programs.

Sometimes the rate spread between seven-year ARM rates and the 30-year fixed isn’t that wide. The example above was based on market rates when I originally wrote this post several years ago.

Today, they’re closer together, around 3.5% for a 30-year fixed and 2.875% for a 7/1 ARM. That’s a spread of 0.625%, which is still a material difference, but not as favorable as it once was.

This spread can and will fluctuate over time. So consider that when making a decision between the two loan programs.

Lastly, note that you should be able to afford the fully-indexed rate on an ARM, should it adjust higher. In other words, plan for rate increases in the future and make sure you can absorb them if for some reason you don’t sell or refinance first.

If a rate adjustment isn’t within your budget, or won’t be in the future when it adjusts, you may want to pay it safe with a fixed-rate mortgage instead of the 7/1 ARM. Believe it or not, seven years can go by pretty fast.

In summary, the 7-year ARM might not be for the faint of heart, whereas a 30-year fixed is pretty straightforward and stress-free. And that’s why you pay more for it.

Read more: 30-year fixed vs. 15-year fixed.

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