30 Year Fixed Mortgage vs. 7 Year ARM

June 6, 2011 No Comments »
30 Year Fixed Mortgage vs. 7 Year ARM

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.

Why Choose the 7-Year 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-year 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, the 7-year ARM is cheaper than the 30-year fixed, or at least it 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 84 months!

Last week, 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.

But is it worth it?

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.

Lastly, note that you should be able to afford the fully-indexed rate on an ARM, should it adjust higher.

So 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.

Put simply, 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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