What is a 7/6 ARM loan and how does it work? Is it risky move or savvy to get a 7/6 ARM? We’ll cover the basics of how these so-called hybrid mortgage loans work and who should or shouldn’t get one.
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What is an ARM Loan?
The acronym ARM stands for adjustable-rate mortgage. An adjustable-rate mortgage is a type of mortgage where the interest rate can change over time based on an interest rate index.
The London Interbank Offered Rate (LIBOR) was commonly used in the past, but it has since been phased out.
The interest rate for an adjustable-rate mortgage is calculated by adding a margin set by the lender to the index. For example, if the index is 2.50% and the margin is 3.00%, the fully-indexed interest rate adds up to 5.50%.
Interest rates for adjustable-rate mortgages can potentially change over the life of the mortgage depending on how the index changes. This means your monthly payment could both increase and decrease over time as well.
Though the index changes over time, the margin is set by the lender at loan closing and will never change during the loan term.
The most common adjustment frequencies for adjustable-rate mortgages are once per year or every six months.
Most HECM reverse mortgages also tend to have adjustable rates.
What is a 7/6 ARM Mortgage?
A 7/6 ARM mortgage is a type of adjustable-rate mortgage that offers a fixed interest rate for the first seven years of the loan term. Once the initial seven years have passed, the interest rate and monthly payment are adjusted every six months based on the index for the remaining 23 years of the loan term.
The “7” in “7/6” ARM specifies that the interest rate is fixed for the first seven years of the loan. The “6” specifies that the interest rate can change every six months.
You may also run across the 7/1 ARM; this type of loan also has a fixed interest rate for the first seven years of the loan, then the rate adjusts once per year based on the index for the remainder of the loan term.
Because the 7/6 ARM mortgage has both a fixed and variable interest rate during the loan term, it’s commonly referred to as a hybrid mortgage.
When it comes to adjustable-rate mortgages, the shorter the fixed-rate period, the lower the initial interest rate. In other words, a 7/6 ARM typically has a lower starting interest rate than a 10/6 ARM, which has a lower starting interest rate than a 30-fixed. The longer the fixed-rate period, the higher you’ll pay for the fixed rate.
7/6 ARM Mortgage Rate Caps
Though the interest rate can change during the last 23 years of the loan, it can only change within built-in limits called caps. This provides a measure of stability so your monthly payment can’t go nuts even if the index skyrockets.
The initial adjustment cap limits how much the rate can increase at the end of the 7-year fixed-rate period. For example, if the initial adjustment cap is 2%, the interest rate on the loan cannot increase more than 2% above the starting interest rate – even if the index has increased much more than that.
A cap also applies to subsequent rate adjustments. This cap, which is known as the periodic adjustment cap, limits how much the interest rate can change during each adjustment period after the initial rate adjustment.
There is also a lifetime adjustment cap, which sets a maximum interest rate beyond which the rate can never increase over the life of the loan. No matter how much the index increases, the interest rate can never exceed the lifetime adjustment cap.
Interest rate caps are often represented using a shorthand notation such 5/2/5, 5/1/5, or 2/2/5. The first number represents the initial adjustment cap, the second number represents the periodic adjustment cap, and the last number represents the lifetime cap.
For example, let’s assume we have a 7/6 ARM mortgage with 5/2/5 rate caps and an initial interest rate of 4%.
Again, the “7/6” means the interest rate is fixed for the first seven years, then adjustable every six months for the remaining 23 years of the loan term.
The “5/2/5” means the first rate adjustment (represented by the first “5”) is limited to a maximum of 5% above the initial interest rate. In other words, using our example, the interest rate cannot exceed 9% at the first rate adjustment (which is 5% above of the starting rate of 4%).
The “2” represents the periodic rate adjustment, which means the interest rate cannot change more than 2% at each adjustment after the initial rate adjustment.
The last “5” represents the lifetime cap, which means the interest rate cannot exceed 5% above the initial interest rate regardless of how much the index increases over the life of the loan.
It’s important to understand that the caps are simply the ceiling that governs how much the interest rate can change. Just because the rate can change, it doesn’t mean the rate will change. Depending on the movements in the index, the rate could increase a little, decrease a lot, or do absolutely nothing. It’s entirely possible that the interest rate for a 7/6 ARM will never increase enough to hit the rate caps.
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Why Get a 7/6 ARM Loan?
So, what is a 7/6 ARM best used for? A 7/6 ARM loan could be a good option if you don’t plan to live in your home for more than seven years.
Because the bank guarantees the rate only for the first seven years, the rate is often much lower than what you would pay for a comparable 30-year fixed mortgage. This reduces your monthly payment and frees up cash that can be used for other financial goals or expenses.
A 7/6 ARM is also a good option if you plan to pay down your loan balance rapidly. Again, the initial interest rate is typically much lower than that of a comparable 30-year fixed mortgage, so more of your payment goes towards the principal.
If you pay down your principal rapidly, your loan balance will be substantially lower by the time the interest rate starts to adjust. Even if the rate hits the caps, the smaller loan balance will limit your payment increases.
In fact, if you’ve paid down your balance enough, your payment could actually decrease even if the interest rate increases to the maximum allowed.
A 7/1 ARM is often a good compromise between the relatively short fixed-rate period of a 5/1 ARM and the substantially higher interest rate of a 30-year fixed. You may want to opt for a 7/1 ARM if you’re not comfortable with how short the fixed-rate period is for a 5/1 ARM and you don’t want to pay the higher rate of a 30-year fixed.
Who Should Avoid a 7/6 ARM Mortgage?
The 7/6 ARM loan is a good option, but it’s important to consider the potential risks as well. Unless you know your income will increase (or expenses decrease), it’s best to avoid a 7/6 ARM if you can barely afford the payments during the initial fixed-rate period.
Again, the payment could increase at the end of the fixed-rate period if the index increases. If the payments become unaffordable, you could be at risk of foreclosure.
We recommend opting for a 7/6 ARM only if you can comfortably manage the payments even if the rate increases to the caps.
Frequently Asked Questions
What does 7/6 mean on an ARM?
The “7” in “7/6” ARM specifies that the interest rate is fixed for the first seven years of the loan. The “6” represents that the interest rate can change every six months.
Is a 5/1 ARM better than a 7/1 ARM?
A 5/1 ARM typically has a slightly lower starting rate than a 7/1 ARM, but the interest rate is fixed only for five years, versus seven years for the 7/1 ARM. Which loan is best depends on your interest rate needs and how long you need the fixed-rate period to last.