What Is a 7/1 ARM Loan and How Does It Work?
Demystify the 7/1 ARM loan. Understand this unique home financing option, its core characteristics, and how its terms function over time.
A 7/1 ARM loan is a type of mortgage where the interest rate can change over its life, unlike a fixed-rate mortgage. An Adjustable-Rate Mortgage (ARM) begins with an introductory fixed interest rate for a set period, then adjusts periodically based on market conditions. The 7/1 ARM offers borrowers a potentially lower initial interest rate compared to a traditional fixed-rate mortgage, providing an initial period of predictable monthly payments.
Understanding the 7/1 ARM Structure
The “7” in a 7/1 ARM signifies an initial fixed-interest-rate period of seven years. During this time, the interest rate on the mortgage remains constant, meaning monthly payments stay the same. This allows for predictable budgeting for the first seven years. The initial fixed rate is often lower than a comparable 30-year fixed-rate mortgage, making it attractive for some.
The “1” indicates that after the initial seven-year fixed period, the interest rate will adjust annually. From the eighth year onward, the interest rate and monthly payment can fluctuate based on prevailing market rates. While the initial seven years offer stability, subsequent annual adjustments introduce variability.
Key Elements of the Adjustable Rate
After the initial fixed period, the interest rate on a 7/1 ARM is determined by combining two primary components: an index and a margin. The index is a benchmark interest rate that reflects general market conditions. Common indexes include the Secured Overnight Financing Rate (SOFR) and the Constant Maturity Treasury (CMT) rate. Lenders select the index at origination, and it remains consistent throughout the loan’s life.
The margin is a fixed percentage added to the index rate to calculate the borrower’s interest rate. This margin is set at origination and remains constant throughout the mortgage term. For example, a typical adjustable-rate mortgage margin can range from 2% to 3%. The margin represents the lender’s profit and operating costs, and determines the fully indexed rate borrowers pay once the loan adjusts.
Interest rate caps limit how much the interest rate can change during adjustment periods and over the loan’s life. There are three main types of caps. The initial adjustment cap limits rate changes at the first adjustment after the fixed period ends. For instance, if the initial cap is 2%, the interest rate cannot increase or decrease by more than two percentage points from the initial fixed rate.
The periodic adjustment cap restricts rate changes at each subsequent annual adjustment. A common periodic cap is 2%, meaning the rate cannot increase or decrease by more than two percentage points from the previous year’s rate.
The lifetime cap sets the maximum interest rate that can be charged over the entire life of the loan. Most ARMs have lifetime caps ranging from 5% to 6% above the initial interest rate. For example, if the initial rate was 4% and the lifetime cap is 5%, the interest rate can never exceed 9% (4% + 5%) during the loan’s term.
The Rate Adjustment Process
At each annual adjustment period, the new interest rate is determined by adding the current value of the chosen index to the fixed margin. For example, if the index is 3% and the margin is 2.75%, the new calculated rate would be 5.75%. This sum, known as the fully indexed rate, represents the base interest rate before any caps are applied.
Interest rate caps limit these changes. The initial adjustment cap is applied at the end of the seven-year fixed period, restricting the first change from the initial rate. Following the first adjustment, the periodic adjustment cap governs rate changes in subsequent annual adjustments. The lifetime cap acts as an overarching limit, ensuring the interest rate never exceeds a specified maximum.
Borrowers receive advance notification regarding upcoming rate changes and their new monthly payment. Federal regulations require servicers to send an initial adjustment disclosure several months before the first adjusted payment. For subsequent rate changes, borrowers receive a notice several weeks before the adjusted payment is effective. These notices inform the borrower of the new interest rate, the recalculated monthly payment amount, and other relevant loan balance information.