7/6 ARM: Definition and How It Works
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Summary:
A 7/6 adjustable-rate mortgage, or ARM, is a loan in which the interest rate is fixed for seven years, and then changes every six months, correlating with the interest rate environment at the time. They often come with a low initial interest rate and caps on how much the rate can go up or down over time. Although this type of loan can be a good option in certain situations, a 7/6 ARM comes with some risk, as your interest rate could go up after the seven-year fixed period.
By and large, Americans are hooked on long-term fixed-year mortgages, and it makes sense. Knowing you will have the same monthly payment 25 years from now makes it easier to plan for your future, whether you want to start a family, invest, or start a business. However, in an environment in which interest rates are high, a 30-year fixed-rate mortgage can seem like a straight jacket. You are locked into the rate unless you get lucky and can refinance at a lower rate. Enter the adjustable-rate mortgage or ARM.
A 7/6 ARM is one version of an adjustable-rate mortgage, which we explain in further detail below. Adjustable rate mortgages used to be much more common, but due to regulations enacted after the financial crisis, they became rarer. We’ll help you determine whether or not this type of loan is right for you.
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Adjustable-rate mortgages vs. fixed-rate mortgages
Adjustable-rate mortgages are mortgages in which the interest rate fluctuates either up or down depending on the interest rate environment. Most people are familiar with the standard U.S. 30-year fixed-rate loan. The interest rate stays fixed for 30 years, and the monthly payments stay more or less constant. Regardless of whether the Federal Reserve’s base rate is 0% or 5%, the interest rate stays the same.
With adjustable-rate mortgages, the interest rate can be fixed for a period of time or not at all. Once the interest rate fluctuates, its movement up or down will correlate to the Fed’s base rate. The Fed’s base rate is the interest rate that the Federal Reserve charges to borrow money or buy treasuries. If that rate moves up, then the interest rate on the mortgage moves up. If that rate moves down, then the interest rate on the mortgage moves down. We can see this indicated in the graph below, which represents the Fed’s base rate vs. retail mortgage rates.
Pro Tip
Americans might not realize that a 30-year fixed-rate mortgage is much less common in other countries. In the United Kingdom and other European countries, for example, mortgages are often fixed for one, three, or five years before changing to a variable rate. In some countries, a 30-year fixed-rate mortgage is unheard of.
What does the 7/6 mean?
The 7/6 means that the initial interest rate will be fixed for seven years and then could change every six months. For instance, take an ARM loan that lasts for 30 years. Let’s say, for the first seven years you have a fixed rate of 5%. Every month you pay off your principal + 5% interest + tangential fees (HOA, property tax). After seven years, that interest rate could change. It could drop to 3.5% or it could rise to 6%.
A 7/6 mortgage also differs from the well-known 5/1 ARM. With a 5/1 ARM, the interest rate is fixed for five years and then changes once a year every year. So now you understand how the mortgage terms work; the number on the left is the fixed term of interest, and the number to the right is how long before it adjusts.
7/6 ARM basics
There are several factors that influence the terms of a 7/6 ARM. Here are some of them.
Interest rate: fixed, then floating
As mentioned above, the interest rate will stay fixed for a period of seven years and then float, or change. There are several factors that will affect the interest rate when it floats every 6 months, including the Fed base rate, the lender’s margin, and interest rate floors and caps.
Intervals
The time frame in between the change in rates is called the adjustment interval. As mentioned above, the initial interval on a 7/6 mortgage is seven years. Once that expires, the lender reserves the right to change the interest rate every six months.
Pro Tip
Make sure you read the fine print in your loan contract if you opt for a loan with floating rates and intervals. Some lenders will have an option for interest rates to go up but not down. You should read your loan agreement in detail anyway, but we suggest you watch out for this if you are shopping for an adjustable-rate mortgage.
Base rate/indexes
Usually, the lender will not follow the Fed’s base rate directly but instead use an index that is linked to the Fed’s base rate. Treasury Security indexes and the Federal Cost of Funds Index (COFI) are two popular indexes that correlate to the Fed’s base interest rate.
Looking for a lender that might have the mortgage rate you have been looking for? Here are some options to consider.
Interest rate caps and floors
As lenders are in the business of risk mitigation, they often insert interest rate caps and floors into the loan agreement. This means there is a ceiling on how much the interest rate can move up in a high-interest environment and how much it can move down in a low-interest environment. Interest rate caps and floors will typically come in three flavors, initial, periodic adjustment caps, and lifetime caps.
Initial cap
The initial cap and floor are the amounts that the rate can move up or down at the initial adjustment. In the case of a 7/6 ARM, this refers to when it adjusts for the first time after the first seven years. For example, your lender might have a parameter that says that interest rates can go no higher than 2% more (cap), or 2% less (floor), than the initial fixed rate.
Periodic adjustment caps
After the initial fixed period, the rate will adjust at intervals. Lenders will often apply a cap and floor to these adjustments. With a 7/6 ARM, every six months, that interest rate will change. A lender might say that the interest rate can only increase by .5% more (cap) or .5% less (floor) every six months throughout the mortgage.
Lifetime cap
The lifetime cap is the maximum amount an interest rate can increase or decrease throughout the lifetime of the loan. For instance, you might speak with a mortgage broker offering you a 7/6 ARM with three other sets of numbers behind it, like 4/1/4. The initial number is the cap/floor, meaning that your rate won’t exceed a 4% increase or decrease after the initial rate adjustment. This is the lifetime cap. The next number, 1, refers to the periodic adjustment cap of 1% either up or down, and the last number is the lifetime cap for the duration of the loan. That last number means that interest rates will not increase or decrease by more than 4% during the term of the loan.
When does a 7/6 ARM make sense?
A 7/6 ARM makes sense for the following reasons:
- The interest rate environment is high, and you hope that your mortgage rate adjusts downward after a period of seven years.
- You can do a cash-out refinance at any point when the interest is significantly lower and get a long-term fixed-rate mortgage.
- You need money for a business or changes in your life, and you don’t want to spend extra money on a fixed-term high-interest rate.
When does a 7/6 ARM not make sense?
- The interest rate environment is low, and you want to lock in a good long-term fixed rate for as long as possible.
- This is your primary residence, and thus, stability with a fixed rate is absolutely key for you to remain in the home.
- The early repayment penalties on an adjustable-rate mortgage are pretty high. If you plan on paying your mortgage back sooner, this could be an issue.
If you want to renovate…
You might find yourself in a situation where you want a 7/6 ARM home equity loan to pull the equity from your home for a renovation. Jason Kopcak, CEO of Altisource Asset Management Corporation, which specializes in renovation financing, says,
“Most professional renovators prefer short-term working capital lines to fund a renovation. This short-term financing preserves the optionality of selling or keeping the property as a rental once completed. Although unlikely to be a common choice, a 7/6 ARM could make sense for an individual home buyer, as opposed to a professional investor, who seeks to pursue a renovation and then remain in the home intermediate term before the first rate adjustment.”
FAQ
Is a 7/6 ARM a good idea?
That depends on the current interest rate environment and your personal situation. As the initial interest rate is fixed for seven years, it could make sense if you plan on moving or selling the home before it adjusts. If you are buying in a high-interest rate environment in which a standard 30-year fixed-rate mortgage loan term is not to your liking, then you might want a 7/6 ARM with the idea that interest rates will surely be down after the initial seven years.
Can you refinance in a 7/6 ARM?
Yes, for example, you can do a cash-out refinance and change loans completely, or you can get a standard home equity loan in addition to your 7/6 ARM.
Can you pay off an ARM mortgage early?
Yes, you can pay off an ARM early. However, the penalties for paying the loan off early will be higher than if you were to pay off a 30-year fixed-rate mortgage early.
Are ARM mortgages a good idea in 2023?
Interest rates did go up quite a bit in 2022, and many home buyers found themselves considering adjustable-rate mortgages rather than locking into a high long-term rate. That said, it depends on your personal situation. You might find that refinancing a fixed-rate mortgage later is a better option than taking the risk of an ARM going up instead of down.
How risky is an ARM loan?
The risk with ARM loans is that the interest rate heads in the wrong direction. In this case, you are still on the hook for a mortgage with sky-high interest rates. However, as most ARMs have interest rate caps and floors, your minimum monthly mortgage payments shouldn’t get ridiculously out of control.
Why is an ARM not a good idea when financing a home?
If you are going to live in the home, for example, you might want the stability of a 30-year fixed rate to help you plan your life. Furthermore, you never know what is going to happen with interest rates, and thus betting on interest rates going lower is just that, a bet. It’s not guaranteed to happen by any means.
Key takeaways
- A 7/6 adjustable-rate mortgage is a loan in which the interest can fluctuate over time depending on the overall interest rate environment. The interest rate is fixed for seven years, and then it can change every six months after that.
- The adjustable interest rate of interest is typically tied to indexes that correlate to the Federal Reserve’s base rate.
- An adjustable-rate loan will, in many cases, come with different interest rate caps and floors that differ from lender to lender.
- An ARM loan is great for those that don’t want to lock themselves into fixed-rate loans for an excessive period of time. If the current Fed rate is high or the borrower wants a lower fixed rate than would be available in longer fixed-rate mortgages, they should consider an ARM.
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