Pros, Cons, and How Much Cheaper Are They?

Lately, I’ve been highlighting loan programs beyond the 30-year fixed now that interest rates on fixed-rate mortgages are no longer favorable.

Today, we’ll compare two popular loan programs, the 30-year fixed versus the 7-year ARM.

Everyone is familiar with the traditional 30-year fixed – it’s a home loan with a 30-year term and an interest rate that never adjusts 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 dig in and determine if it’s time to start looking beyond the 30-year fixed to potentially save some money on your home loan.

Key Facts About 7-Year ARMs

• They are hybrid home loans that are fixed for 7 years and adjustable for the remaining 23 years
• Offer an interest rate discount for the risk of future (higher) rate adjustments
• 7/1 ARM is fixed for seven years and annually adjustable thereafter
• 7/6 ARM is fixed for seven years and adjusts every six months thereafter
• Pay attention to the difference in start rate to determine if it’s worth it vs. a 30-year fixed
• Plan for the worst seven years from date of loan funding (if rates jump a lot higher)

How the 7/1 ARM Works

• You get a fixed interest rate for the first seven years of the loan term
• After that the rate becomes annually adjustable for the remaining 23 years of the 30-year loan term
• Many borrowers don’t keep their mortgage/home that long so you may never actually face a rate adjustment if you refinance or sell prior to seven years
• It’s an option to consider alongside the more popular 30-year fixed now that mortgage rates are no longer on sale

A 7/1 ARM is an adjustable-rate mortgage with a 30-year term that features a fixed interest rate for the first seven years and a variable rate for the remaining 23 years.

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, or even year-to-year.

So if the starting interest rate is 6%, that’s where it will remain until it’s first adjustment in month 85.

For all intents and purposes, the loan program offers borrowers a fixed rate for a very lengthy 84 months.

During the remaining 23 years, the rate is adjustable, and can change just 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…

You Might Also Come Across the 7/6 ARM

Lately, more mortgage lenders have been pitching ARMs that adjust every six months instead of annually.

So you may come across a “7/6 ARM,” which as the name implies is fixed for the first seven years and then adjusts twice each year (every six months) thereafter.

The good news is it’s not all that different than the 7/1 ARM. You still get the seven years of fixed rate goodness, which is arguably the most important feature.

Then you’re subject to a rate adjustment every six months. If you still have your ARM at that point, you can explore a refinance if rates are favorable.

Otherwise, you’ll need to contend with more adjustments (two each year instead of one), though it should be noted that rates can move both up and down.

If you prefer one loan type over the other, shop accordingly to see which lenders offer the 7/1 ARM vs. the 7/6 ARM, or vice versa.

Why Choose the 7/1 ARM?

• You can obtain a lower interest rate (and monthly payment) for a long period of time
• Might be significantly cheaper relative to available fixed-rate mortgage options
• This loan type still features a fixed interest rate for a full seven years
• Meaning you may effectively hold a fixed-rate mortgage for as long as you own your home or until you refinance

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 that low rate month after month for years.

How Much Lower Are 7/1 ARM Rates vs. the 30-Year Fixed?

At the time of this writing, mortgage rates on the 7-year ARM are being offered at around 6%, while the typical rate on a 30-year fixed is about 6.75%.

[What mortgage rate can I expect?]

That’s an OK rate spread, especially after a long period where fixed-rate mortgages were actually cheaper than ARMs.

This strange phenomenon took place because the Fed pledged to buy up long-term fixed-rate mortgage securities, driving mortgage rates down in the process (it was known as QE).

As such, ARMs weren’t offering much of a discount (if any) and often weren’t even worth looking into in most cases.

But in normal times, which we’re starting to return to, you might find an even wider spread between the two products.

For example, several years back the 7-year ARM averaged 3.64%, while the average rate on a 30-year fixed was 4.69%.

That resulted in a monthly payment difference 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?

I’ve also come across 7/1 ARM rates as low as 5.375% lately, which would represent a difference of 1.375% versus a comparable 30-year fixed at 6.75%.

Let’s Calculate the Potential Savings of a 7/1 ARM

7-year ARM vs. 30-year fixed

$300,000 Loan Amount	7/1 ARM	30-Year Fixed
Mortgage Rate	5.375%	6.75%
Monthly P&I Payment	$1,679.91	$1,945.79
Total Cost Over 60 Months	$100,794.60	$116,747.40
Remaining Balance After 84 Months	$265,808.29	$272,362.94
Total Savings	$22,507.45

Imagine you’re able to find a 7/1 ARM at a rate of 5.375% instead of a 30-year fixed at 6.75%.

That’s a big difference in rate, affording you a monthly payment that’s about $266 less per month.

Not only would you save money long-term, but you’d also save monthly, meaning you could 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.

The lower rate would also pay down your principal balance faster, meaning you’d accrue home equity faster.

To that end, your remaining balance after 84 months would be about $6,500 lower with the ARM.

Taken together, you’d be more than $22,500 ahead after seven years thanks to a smaller outstanding loan balance and lower monthly payment.

Are the Lower 7/1 ARM Rates Worth the Risk?

• You have to weigh the risk and reward of the 7/1 ARM
• While you receive a discounted interest rate for a lengthy seven years
• Perhaps .50% to .625% lower than the 30-year fixed during normal times
• Consider the risk of the rate adjusting higher in year 8 and beyond unless you sell your home or refinance before that time

Now let’s talk about risk. As noted, 7/1 ARM rates are typically cheaper than the 30-year fixed, but how much depends on the current rate environment.

I’ve found much cheaper rates at credit unions (a good place to look if you want an ARM!), but many bigger lenders and banks might only offer a .50% discount.

At that point, the savings may not justify the risk of a higher rate after first adjustment.

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 perhaps lower) in the future.

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 the mortgage within seven years, the loan program could make a lot of sense.

But you’re still timing the market to some degree, hoping it’s a good time to sell at some point, or that refinance rates are attractive during those 84 months.

Compare Rates/Costs to the 30-Year Fixed. Do the Math

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.

At the moment, the spread is beginning to widen, making adjustable-rate mortgages favorable again.

However, you do need to put in more to shop around because ARM rates can vary a lot more from bank to bank than fixed rates.

If you put in the legwork, you may find a bank or lender willing to offer a more substantial discount.

For example, credit unions tend to offer lower ARM rates and could offer a wider spread versus the competition, namely banks and big household lenders.

Regardless, this spread can and will fluctuate over time, so always take the time to 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 After It Resets

• It might be wise to look at the worst-case scenario
• Which is the maximum interest rate your loan can adjust to
• This ensures you can handle the larger monthly mortgage payments
• Assuming you don’t sell or refinance or are unable to and your rate adjusts significantly higher

Also 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 SOFR) 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.

Refinancing Your 7-Year ARM in the Future

The good news is even if mortgage rates 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, or refinance at more attractive terms.

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 if spreads are wide.

To know for sure, use a mortgage calculator to compare the costs of each loan program over your expected tenure in the property.

7/1 ARM Frequently Asked Questions

What is the 7/1 ARM rate today?

Rates vary considerably by bank, lender, and credit union, and by your individual loan scenario. But you can get a feel for rates by searching lender rate pages.

I’ve found that the lowest 7/1 ARM rates are offered by local credit unions. Search for one in your city or state and compare it to the national banks and lenders to see what I mean.

Can you refinance out of a 7/1 ARM at any time?

Yes, as long as you qualify for the mortgage. A refinance isn’t much different than a home purchase loan. You’ll still need to qualify based on income, employment, credit score, etc.

If rates drop and/or your first adjustment is imminent, you can look into a refinance to secure a new fixed-rate term on an ARM or go with a fixed-rate mortgage.

For example, you can refinance into another 7/1 ARM or a 30-year fixed.

How long does the 7/1 ARM last?

Despite it being called a 7-year ARM, it’s a 30-year loan just like the 30-year fixed. However, the seven refers to the fixed rate period, which is only the first seven years, or 84 months.

The remaining 23 years of the loan are adjustable, either once annually in the case of the 7/1 ARM, or biannually in the case of the 7/6 ARM.

What happens when the 7-year ARM expires?

After seven years, the rate is no longer fixed and becomes adjustable.

To determine your interest rate, the lender uses the combination of your margin (check your loan documents for this number) and the corresponding mortgage index.

Together, these two figures make up your fully-indexed rate. And every six or 12 months, the lender will adjust your rate based on changes to the index. The margin is always fixed.

For example, if the margin is 2.5% and the index is 4.75%, the rate would be 7.25%.

At the next adjustment, if the index rises to 5%, the new rate would be 7.50%.

Is there a penalty for paying off an ARM early?

Generally, no. Prepayment penalties were very common in the early 2000s, but very uncommon today. But always ask to be sure.

If there is no penalty, you can refinance or sell at any time without paying any sort of early payoff fee.

How much can a 7/1 ARM go up?

It depends on the ARM caps, which dictate movement each adjustment period. Typically, you’re looking at 2% caps each adjustment period and perhaps 5% max for the life of the loan.

That’s still sizable, meaning if your start rate were 5.5%, the rate could potentially go to 10.5%!

Is the 7/1 ARM a good idea right now?

It’s certainly becoming more compelling with fixed-rate mortgages so expensive relative to a few years ago.

But it depends how much lower the rate is, what your plan is for the property (expected holding period), interest rate outlook, and so on.

Ultimately, you are taking a risk with an ARM and need a plan for all possible scenarios.

7/1 ARM Pros and Cons

The Good

• You get a fixed interest rate for an entire seven years (84 months!)
• The rate is typically much lower than a 30-year fixed
• More of each monthly payment will go toward the principal balance instead of interest
• Most homeowners move or refinance in less time than that
• So you can enjoy a lower mortgage rate without worrying about a rate adjustment

The Bad

• It’s an ARM that can adjust higher after seven years
• Monthly payments may become much more expensive if you hold onto it
• The interest rate discount may not be worth the risk of the rate adjustment
• More stress if you hold the mortgage anywhere near seven years
• Could be stuck with the loan if unable to sell/refinance once it becomes adjustable

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