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 during the entire loan term. 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 rolled into one. Sounds a little bit more complicated…
Let’s break it down. During the first seven years of the loan term, the mortgage rate is fixed, meaning it won’t change from month-to-month. For all intents and purposes, the loan program offers borrowers fixed rates for a lengthy 84 months.
During the remaining 23 years, the rate is adjustable, and can change once per year. That’s where the number “1” in 7/1 ARM comes in.
This makes the 7-year ARM a so-called “hybrid” adjustable-rate mortgage, which is actually good news. You essentially get the best of both worlds. A lower interest rate thanks to it being an ARM, and a long period where that rate won’t change.
It affords you two additional years of fixed payments when compared to the 5/1 ARM. And those 24 extra months might come in handy…
Why Choose the 7/1 ARM?
You probably don’t want your mortgage rate (and mortgage payment) to change all the time, especially if your rate increases, which is probably the likelier outcome.
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!
As noted, most homeowners don’t keep their home loans that long anyway, so there’s a decent chance the borrower will never see that first adjustment, yet still enjoy those low rates month after month.
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.
That’s a difference in rate of more than a percentage point, and a difference in payment of $122.28 a month, $1,467 per year, and over $10,000 over the first seven years on a $200,000 loan amount. Not bad, eh?
Let’s look at the math:
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 (like high-interest credit cards) or build up an emergency fund.
Are Lower 7/1 ARM Rates Worth the Risk?
And you don’t want to get caught out if mortgage 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 sell or refinance within seven years, the loan program could make a lot of sense, assuming it’s a good time to sell or refinance rates are attractive at some point over those 84 months.
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. Obviously the upside is diminished and it gets riskier if the two loan programs are pricing similarly.
Make Sure You Can Afford the 7/1 ARM
Lastly, note that you should be able to afford the fully-indexed rate on a mortgage ARM, should it adjust higher.
After those seven years are up, the interest rate will be calculated using the margin and the index rate (such as LIBOR) tied to the loan. This rate could be considerably higher than what you were paying.
In other words, expect and plan for rate increases in the future and make sure you can absorb them if for some reason you don’t sell your home or refinance your mortgage 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.
The good news is even if mortgage rate are higher seven years after you take out your loan, you’ll still be pretty far ahead from all the savings realized during that time.
You’ll have a smaller outstanding loan amount thanks to more of your monthly payment going toward the principal balance and you’ll have saved a ton on interest.
So even if refinance rates are higher in the future, or you simply let it ride with a rate adjustment, you may still come out ahead, at least for a little while. If nothing else, the savings during the first seven years may give you breathing room to pay more in the future.
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.
If you’re certain you won’t be staying in a property for more than five or so years, it could be a solid alternative and a big money saver. To know for sure, use a mortgage calculator to compare the costs of each loan program over your expected tenure.
7/1 ARM Pros and Cons
- A fixed rate for a whole 7 years (84 months!)
- An interest rate that is lower than a 30-year fixed
- Most homeowners move or refinance in less time
- So you can enjoy a lower mortgage rate without worrying about a rate adjustment
- It’s an ARM that can adjust higher after 7 years
- Monthly payments may become much more expensive
- The interest rate discount may not be worth the risk
- More stress if you hold the mortgage anywhere near 7 years
Read more: 30-year fixed vs. 15-year fixed.