If you have been thinking about buying a home in the past year or two, it has been a rollercoaster ride for many looking to buy a home. First, home prices were appreciating so fast, and then by the spring of 2022 interest rates started to rise on home loans.
The rate on a 30-year fixed was in the lower 3 percent range and peaked in October at around 7.375 percent. With such a drastic rise, it left a lot of homebuyers wondering how homes could be affordable for them. So how can reduce your monthly payment and make your mortgage more affordable?
Consider a 7/1 ARM or a similar Adjustable Rate Mortgage.
What Is A 7/1 ARM?
A 7/1 ARM is a hybrid mortgage product. The ARM stands for Adjustable Rate Mortgage.
Unlike a 30-year fixed and 7/1 ARM doesn’t stay at a fixed rate for the entire life of the loan. It stays at a fixed rate for the first 7 years and then can adjust up or down every year thereafter for the life of the loan.
The benefit of an Adjustable Rate Mortgage is the bank is taking less risk by only offering a fixed rate. In doing so they offer a rate lower than the 30-year fixed.
How Does A 7/1 ARM Work?
A 7/1 ARM will stay at a fixed rate for the first 7 years of the loan. It will adjust on the 8th year and every year after for the remainder of the 30 years.
Break it down. The first number is the length of the fixed period. The second number is how often it can adjust after the initial fixed period.
Currently, some banks are offering ARM products that adjust every 6 months. In that case, you will see it as a 7y/6m ARM.
There Are 5 Components To An Adjustable Rate Mortgage
If you are a consumer looking to save a little bit of money on your mortgage by using an adjustable-rate mortgage there are four components to the product you should be aware of:
Index
The interest rate rise or decrease is not random. It is tied into a number of financial indexes. The Monthly Treasury Average or the LIBOR index are popular indexes used. When it adjusts it rises and falls based on the index.
Margin
The margin is the amount above and beyond the lender tacks onto the index. For example, if the rate for an index today is 5.625% and there is a 2% margin added on then the interest rate would be 5.625%. The margin is in your loan agreement and will not change.
Initial Interest Rate
The initial interest rate is the interest you will be charged in the initial fixed-rate period of the ARM product.
Adjustment Period
The interval at which your mortgage will adjust after the initial fixed-rate period.
Adjustment Caps
There are three caps on a 7/1 ARM to be aware of. First is the amount it caps in the first adjustment year. Second is the cap it can adjust to in subsequent years. And finally the lifetime cap.
A 7/1 ARM typically has a 1-2% adjustment cap and a 5-6% lifetime cap. If we take the example above at an initial interest rate of 5.625 based on the caps it could adjust to as high as 7.625% in the eighth year and could go as high as 11.625% over the life of the loan.
Pay attention to see if there is an initial cap on the eighth year. It could be higher than 2%.
Note, that while caps are in place for interest rate increases, they are also in place for decreases as well.
How Much Money Can I Save With A 7/1 ARM?
The delta or rate spread between the interest rate on a 30-year fixed rate and a 7/1 ARM can be variable. And, it can vary from bank to bank as well as product.
It all has to do with how a lender is trying to fill out their portfolio of loans and market conditions. It pays to shop around if you are considering a 7/1 ARM.
A rate spread today on a 7/1 ARM vs a 30 Year Fixed is approximately 3/8 to 1/2%. But there are times when it can be as little as 1/8% to 1/4% and as much as 1%.
Take a half of a percent rate spread on a $500,000 mortgage. At a 6.125% rate for a 30-year fixed your principal and interest would run $3038. Whereas a 7/1 ARM at 5.625% would be a monthly payment of $2878.
A difference of $160 a month. That saves you $1920 a year or over the 84 months of fixed payments a total of $13,040.
The Reality
The average homeowner holds a mortgage for less than 10 years. Not because they pay off what they owe on the home.
But, because they go on to purchase another home or refinance their home.
The reality is even if you locked a 30-year fixed rate in today, you will probably refinance in the next few years as many experts feel the interest rates will drop to the low or mid 5% range. And if you do hold your mortgage there is a good chance you will move in the next 7 years.
The Pros and Cons of a 7/1 ARM
Pros
Lower initial payment during the first 7 years of the loan compared to a 30-year fixed.
Payments could decrease after the initial period if interest rates have lowered.
Flexibility. If you know you are buying for the short term it allows you to save money every month and either refinance or sell.
Cons
After the initial fixed-rate period your monthly principal and interest payment can go up.
ARMs are complicated. Make sure you understand the caps and when and how your interest rate will increase or decrease.
As much as you plan things in life change. Not only do you have your personal circumstances you have market conditions of which you have no control.
Consider Other Adjustable Rate Mortgage Products
When I started this article I chose the 7/1 ARM to right about because I believe the 7 years fixed period is enough time to weather ups and downs and in my experience, many of my clients do not hold a mortgage for that long. They either refinance or move.
But there are other Adjustable Rate Mortgages to choose from 3/1, 5/1, 10/1 and even 15/1. If you are thinking about using an ARM product to save on your monthly mortgage payments consider all your options.
Just like the 7/1 ARM you can get an initial fixed period of 3, 5 or more years. Generally the lower the fixed rate period the lower your starting interest rate.
But look at all your options there are times when banks are trying to fill out a certain segment of their loan portfolios and you could find a 10/1 or 15/1 year ARM for a similar rate as a 7/1.
Is A 7/1 ARM Right for Me?
What loan product you use is a personal decision and can vary from homebuyer to homebuyer. If you are considering using a 7/1 ARM or another Adjustable Rate Mortgage consider the following:
The Savings
The monthly savings an ARM provides you is attractive. Think about this. The $160 a month might not seem like a lot but that would fund your homeowner’s insurance over the initial loan period.
Your Housing Goals
If your goal is to stay in your house for less than the initial interest rate period then certainly consider a 7/1 ARM.
Interest Rates Will Go Down
If you suspect interest rates will go down certainly a 7/1 Adjustable Rate Mortgage would be a great option. You can refinance into a lower 30-year fixed rate or continue to ride interest rates down for further savings.
Other Ways To Lower Your Interest Rate
Using a 7/1 ARM is not the only way to get a better interest rate. Realize when you see rates online they are usually reserved for the very best credit profiles. If your credit is only fair and your debt-to-income ratio is higher, there are what are called price bumps that will add basis points to your final mortgage rate.
Improving your credit score can impact your final interest rate. For every 20-point improvement in your credit score your interest rate changes for the better.
Your debt-to-incomeWhat Is Debt To Income Ratio When Applying for a Home Loan? ratio can also impact the interest rate you are offered on a loan. If you have a low debt-to-income ratio, you could see an improvement in your interest rate.
Last Thoughts
If you decide to finance your next home purchase with a 7/1 ARM or any adjustable rate mortgage, go into knowing the details. Don’t be shocked in year eight when your 6% interest rate jumps to 8%.
Plan on what your end goal is when you use a 7/1 ARM. Are you planning on refinancing or moving before the 7 years are up?
Will there be a significant change in your income that an adjustment in rate wouldn’t be a big deal?
Finally, make sure you compare rates from different banks and certainly see if a 10/1 or 15/1 ARM provides enough savings to be worthwhile.
Other Real Estate Resources
Getting a home loan is a major part of buying a new home. While a conventional loan is the most popular, there are government loans that may make it easier to qualify. Luke Skar discusses the benefits of an FHA, VA or USDA loan.
Some lenders will require repairs before lending on a home. Andy Kolodgie provides information on what repairs a lender may require before closing on a loan.
What Is Debt To Income Ratio When Apply for a Home Loan? is provided by Kevin Vitali, your local Massachusetts REALTOR. Thinking of buying a home? Call me for your free home consultation and let’s get you started on a new home. 978-360-0422
