adjustable rate loans Archives

How the 7/1 ARM Works

The name of the ARM lets you know how it will work. In the case of the 7/1 adjustable rate mortgage, the rate is fixed for 7 years. After the 7 years, the rate adjusts once per year, on the same date. Next, we will cover the rates and how they work.

The Initial Rate

Th initial rate is often known as the ‘introductory rate.’ This rate is usually lower than any fixed rate you can get. It’s how lenders entice you to take the ARM loan. You can think of the lower rate as the ‘reward’ for taking the risk of an adjustable loan. You get to enjoy the lower rate for 7 years, but then the rate will start adjusting.

Understanding the Adjustments

After the first 7 years, your rate will adjust. The amount it adjusts depends on two factors:

Margin – This is a predetermined number that the lender tells you when they quote you the interest rate. This number never changes.

Index – This is the chosen index that determines your rate, such as the LIBOR or T-Bill rate.

On your adjustment date, the lender adds the current value of the chosen index to the margin to come up with your rate for the next 12 months.

How you are Protected

It might seem scary to have a rate that can just increase incredibly high or fall very low. Luckily, there are protections in place, called the caps and floors.

The cap is the highest the interest rate can go. You’ll have a few caps on your 7/1 ARM. You’ll have an initial adjustment cap. This limits how much the rate can change during the first adjustment only. After the first adjustment, this cap is no longer valid.

You’ll also have a periodic cap, This puts a limit on how much your rate can change at one time. While this cap will vary by lender, it is commonly 2%. This helps give you a little peace of mind knowing that if your rate does increase, it won’t be a drastic amount that makes the payment completely unaffordable.

Finally, there is a lifetime cap. This limits how much the rate can change over the life of the loan. For example, if your lifetime cap is 5%, you cannot change more than 5 points. If it does increase as much as 5 points at any given time, it will not increase any further for the life of the loan.

Many people use the 7/1 ARM to take advantage of the lower interest rate for 7 years, knowing that they will move or refinance before the rate adjusts. It’s a good way to save a little money on your payments in the short-term. If you know you will stay in the home for the long-term and you have no desire to refinance, it may not be the best choice. Weigh the pros and cons and think about your future plans to help you decide if this loan is right for you.

If you are on the cusp of an approval or denial for a mortgage due to a high debt ratio, you may find help in an ARM loan. The adjustable rate loan gives you a low introductory rate. Oftentimes, this rate is lower than any fixed rate you can obtain. This could mean a lower mortgage payment, which gives you a lower debt ratio.

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In some cases, borrowers can even borrow more money because of the lower interest rate, again because the payment is lower. This pertains to borrowers that aren’t on the cusp of approval/denial, but that need to borrow more than the fixed rate loan will allow.

Keep in mind, sometimes this method works, but it depends on the lender.

Understanding the ARM Loan

The ARM loan is unique because it provides you with a lower introductory rate for a specified period. After that period expires, you are subject to an adjustable rate. The typical adjustable rate loan adjusts once per year.

The most common ARM loans include the 3/1, 5/1, and 7/1. This means you can get a fixed, introductory rate for either 3, 5, or 7 years. After that period, the rate adjusts according to the corresponding index and margin.

Each lender will give you the factors concerning how the rate will adjust. For example, one lender may use the LIBOR index, while another may use the Treasury index. This is the ever-changing value that your loan is subject to during the adjustment period. This is the one factor you cannot predict. You can look at the historical pattern of the index, but there’s no foolproof way to predict how it will react in the future.

The lender will also give you a margin. This is the number they come up with that they add to the index. This number does not change during the term of your loan. For example, if your margin is 2% and the index on the date of your adjustment is 4%, you would have a 6% rate for the next 12 months.

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Luckily, there are also certain caps the lender will put on your ARM loan. They determine the maximum amount your rate can change during the following periods:

Initial cap – This is the maximum amount your rate can change for the first adjustment
Periodic cap – This is the maximum amount your rate can change for any one period
Lifetime cap – This is the maximum amount your rate can change over a lifetime

Qualifying for the ARM Loan

Qualifying for the ARM loan is where things get tricky. You may find lenders that qualify you based on the introductory rate. If that’s the case, then you may be able to qualify for a larger loan amount because your payment will be lower, at least initially.

If the lender qualifies you based on the fully indexed rate (the worst-case scenario), though, you may not be able to get that larger loan amount. Many lenders tend to go this route because it ensures them that you can afford the payment even when the interest rate hits the most it can hit based on the caps on your loan.

If you need that larger loan amount, it pays off to shop around and find a lender willing to use the introductory rate for qualification purposes. There’s no rhyme or reason as to what lenders use, but in general, you will find the following:

FHA loans use the initial interest rate for qualifying purposes
Conventional lenders will use the initial interest rate for 7/1 and 10/1 ARMs
Conventional lenders will add 2% to the initial interest rate for any ARM shorter than a 7/1

Yet again, many lenders just use the fully indexed rate as it provides them with the most protection.

If you are close to the maximum debt ratio, it pays to look at different loan programs. For example, the conventional loan only allows a 28/36 debt ratio. This means a 28% front-end ratio and a 36% back-end ratio. FHA loans, on the other hand, allow a 31% front-end ratio and a 43% back-end ratio. This gives you a little more wiggle room should you need more buying power. FHA lenders usually use the initial rate too, which will help you qualify for a larger loan

It’s always a good idea to make sure you can afford the loan at its worst. Even if the lender doesn’t use this method, you personally should consider it so that you don’t take a loan that gets you in over your head. Being house poor could cause you to default on your loan in the future. Knowing the worst-case scenario in terms of interest rates, though, can help you choose the ARM that works best for you.

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