As a current or prospective home buyer, you know that every new home comes with different mortgage needs. Depending on your financial and real estate goals, you might look for alternatives to the standard 15- or 30-year fixed-rate mortgage to get the most from your money. That’s where adjustable-rate mortgages (ARMs) come in.
In this article, we’ll go over 7/6 ARM loans and how they work. We’ll also compare this option to other mortgages you might be considering.
What Does 7/6 ARM Mean?
A 7/6 ARM is a mortgage loan that starts with a fixed interest rate for the first 7 years of the loan (the “7” in 7/6). After the fixed-rate period ends, the lender adjusts the mortgage rate every 6 months according to market conditions for the remainder of the loan term (the “6” in 7/6).
With ARMs, the interest rates depend on market conditions. Like fixed-rate mortgages, ARMs typically have 15- or 30-year terms but have variable rates over the lifetime of the loan. Other ARMs may have different rates of adjustment, such as annually or every 2 – 5 years for the remainder of the loan.
How Does a 7/6 Adjustable-Rate Mortgage Work?
Not all ARMs work the same, so it’s important to consider the different factors of each when you shop for loans.
The initial interest rate for a 7/6 ARM is usually lower than the going rate for fixed-rate mortgages. Once you close your mortgage deal, you’ll lock in that rate for the first 7 years of the loan.
When the initial 7 years are up, your lender will reset the interest rate every 6 months based on the market index and margin. Even in a stable market, your monthly payments could fluctuate quite a bit during the lifetime of your loan.
You can generally expect your interest rate to increase, but don’t worry about the prospect of disproportionately high payments. Most ARMs have interest rate caps in place to keep payments at manageable levels. Lenders would much rather have you continue to make payments than risk defaulting on your loans.
The 2/2/5 cap rate is among the most common structures. We’ve listed what each number denotes in the order they appear:
- Initial adjustment: Limits the percent increase for the initial rate adjustment following the end of the fixed-rate period. For the 2/2/5 structure, your first adjustment following the fixed-rate period can’t raise the interest rate more than 2% higher than your original rate.
- Subsequent adjustment: Limits the percent increase in subsequent adjustments. In this case, subsequent adjustments can’t raise the interest rate more than 2% higher than the previous adjustment’s rate.
- Lifetime adjustment: Shows the max interest rate above your initial fixed rate. This is sometimes referred to as the interest rate cap. In a 2/2/5 loan, the interest rate may never exceed 5% more than your initial interest rate.
While caps limit the increase of your interest rate, they also come with a floor that limits how much the rate can decrease following the initial adjustment.
There are a few adjustment interval terms found with ARM loans, but 1 year or 6 months are the most common. The adjustment interval, or adjustment period, tells you how often the loan’s interest rate is adjusted.
As shown earlier, you can see how these intervals are broken down by looking at the 7/6 ARM loan name itself. The 7 represents the first 7 fixed-rate years, while the 6 represents the adjustment interval following the introductory rate. For a 7/6 ARM, the interest rate is adjusted every 6 months for the remainder of the loan’s life.
Index and margin
In the past, lenders also relied on interbank offered rates like the London Interbank Offered Rate (LIBOR), which was measured based on bank activity. As of 2022, LIBOR will be phased out for the Secured Overnight Financing Rate (SOFR), which uses certain financial market indexes set by the Federal Reserve Bank, such as the constant maturity treasury.
Once lenders calculate your rate’s index, they’ll add a base percentage or a margin to the index rate. Lenders determine margins based on the borrower’s credit score. Consequently, having a better credit score can help you get a lower margin rate.
How Does a 7/6 ARM Compare to Other Mortgages?
Before committing to a 7/6 ARM, you might want to check out a few other mortgage options. Each comes with its rates, terms, advantages and risks.
7/6 ARM vs. 7/1 ARM
Both loan options typically carry lower interest rates than fixed-rate loans, but 7/1 ARMs readjust interest annually while 7/6 ARMs readjust semi-annually.
7/6 ARM vs. 5-year adjustable-rate mortgages
Instead of a 7-year fixed-rate term with a 7/6 ARM loan, you can opt for a shorter term with a 5/1 or 5/6 ARM loan. Although you won’t get to take advantage of the fixed rate for as long, 5-year ARMs generally have lower initial interest rates than 7-year ARMs.
7/6 ARM vs. 10-year adjustable-rate mortgages
The longest fixed-rate term you’ll find with ARMs is a 10-year ARM, either as a 10/1 or 10/6 ARM. Since 10-year ARMs have a longer fixed-rate term, they’re a lower risk option for borrowers that aren’t in a hurry to sell their homes before the variable rate kicks in. On the downside, 10-year ARMs have slightly higher initial interest rates than 7/6 ARMs.
7/6 ARM vs. fixed-rate mortgages
A 7/6 ARM typically has an interest-rate advantage over 15- and 30-year fixed-rate mortgages, at least during the fixed-rate term. ARMs start with lower interest rates than fixed-rate mortgages, but the interest advantage can be lost if subsequent variable rates are high enough to make the average ARM interest rate higher.
- 30-year fixed: A $200,000 7/6 ARM at 3% with a 2/2/5 structure and loan period of 30 years could end up costing $153,803 in interest over the life of the loan. In contrast, an amortized 30-year 3.5% fixed-rate mortgage of the same amount should only cost about $123,312 in interest.
- 15-year fixed: With a 15-year fixed-rate mortgage, you’ll have higher monthly payments than with a 7/6 ARM, but you’ll have a lower interest rate with more cash paid directly to the principal balance. A $200,000 15-year 3% fixed-rate mortgage should only cost about $48,609 in interest.
What Should You Consider When Looking at a 7/6 ARM?
Most 7/6 ARMs come with interest rate advantages that can help you reduce your interest costs in the short term. But they also come with other considerations.
- Qualifications: Most 7/6 ARM loans have qualifications similar to any other conventional mortgage. You’ll probably need a credit score of 640 or better and a debt-to-income (DTI) ratio of 43% or lower to qualify.
- Loan-to-value (LTV) ratio: The maximum permitted LTV is 80%. So you’ll need a 20% down payment if you plan to buy a home with a 7/6 ARM. This is different from some loan programs that let you buy with a lower LTV.
Types of properties: You can get a 7/6 ARM to purchase a wide range of properties including single-family, multifamily affordable housing, seniors or student housing or a home in a manufactured housing community.
Your APR is the total cost to borrow including interest and fees. If two 7/6 ARM loans offer the same interest rate but one has a higher APR, ask why.
When Might a 7/6 ARM Make Sense?
In the right scenario, a 7/6 ARM might make the most sense for you over fixed-rate or other mortgage options.
For instance, a 7/6 ARM can be a great option if you’re not planning to settle down at the property you’re buying. If you intend to sell your home within a few years of purchasing it, getting a 7/6 ARM means that you’ll only pay a lower fixed interest rate and never have to deal with the later and higher-risk variable rates.
Keep in mind, most 7/6 loans don’t let you pay off the loan within the first year and you’ll pay a 1% prepayment penalty every year after that. So if you’re looking to flip a home, a 7/6 ARM may not be the best option for you.
Interest rates are high
If interest rates are high when you plan to buy, a 7/6 ARM can help you secure a lower interest rate in the short term. That way, if interest rates drop after the first 7 years, you may not see a major change in your interest payment. Or if you see that interest rates are set to rise, you can try to refinance before your 7-year introductory period ends.
You anticipate earning more income
Some professions may not pay a lot at the start but may offer greater rewards later in your career. If a higher rate might affect the affordability of your mortgage payments, it’s best to ensure that you’re on a higher-income path so you’ll be able to keep up with increased rates later down the line.
You want to convert to a fixed-rate loan
One unique feature of a 7/6 ARM is that you can convert it to a 7- or 10-year fixed-rate mortgage with minimal re-underwriting. To qualify, you’ll need to wait about 1 year and need to have made all your payments on time and in full.
How could that affect you? Let’s say you’re starting out in a field like law or medicine where starting salaries are relatively low and student loans are high, but there’s enormous potential to earn more money after you get through being an associate at a law firm or a residency program at a hospital.
If your salary increases significantly before the end of your 7-year introductory period, you may have the income to lock in that lower interest rate and own your home in less time. All without having to go through the process of refinancing your home with a new lender or worry about having to refinance when interest rates are higher than they were when you first bought your home.
Is a 7/6 ARM Right for You?
Now that you’ve got the workings of a 7/6 ARM loan down, you can start considering if it might be a good solution in your home-buying process.
Remember: regardless of which loan you choose and the type of market you’re buying in, keeping your credit and finances healthy is one of the best ways to get the best deal on your mortgage.
Keep a close eye on your finances as you’re looking into purchasing a property, and make sure you keep your mortgage payments consistent and on time after you’ve closed the deal.