If you are trying to save money on your mortgage, you might want to explore the world of ARM loans. The adjustable rate mortgage might look scary at first, but once you understand it, you’ll see its many benefits.
The adjustable rate mortgage isn’t for everyone. We’ll discuss who benefits the most from this type of mortgage and what to expect.
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 After the first adjustment, this cap is no longer valid.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.