A 7/1 adjustable rate mortgage (ARM) is a loan that begins as a fixed rate loan before converting into a variable rate loan seven years into the loan term. The interest rates changes on an annual basis thereafter. A 7/1 ARM mortgage usually has a low interest during the first seven years, but the rate can rise or fall when the initial fixed rate period ends.
The initial rate on a 7/1 ARM mortgage is usually higher than the rate available on interest only mortgages but lower than the rates available on 15 or 30 year fixed mortgages. When the rate resets, the new rate is normally based on an index that reflects the average yield being paid on 10 or 30 year bonds. The new rate is fixed at a certain margin above the index. Some lenders have a steady margin throughout the adjustable period of the loan, while other mortgage contracts include a detailed list that shows the margin that will be added to the index rate during each year of the mortgage.
A 7/1 ARM mortgage amortizes over 30 years, which means that the payments are structured so that the principal and interest owed will be paid off by the end of the 30 year term. Every time the rate resets the borrower's monthly payment changes, but rate caps are included in the mortgage contract that prevent rates from rising above certain levels or falling below specified minimums. Borrowers can use a 7/1 ARM mortgage to buy or to refinance a home, but these loans can only be used in the first lien position and not as second lien loans.
People often use 7/1 ARMs to buy properties in which they intend to live for only a few years so that they can keep their mortgage payments to a minimum during the time that they own the property. 7/1 ARMs are popular when rates on fixed mortgages are high, but when rates on fixed term loans are very low, 7/1 ARMs are less widely used because there is little difference between the interest rate and payment on a 7/1 ARM mortgage and the rate and payment on a fixed rate loan. Many lenders also offer 5/1 ARMs which work similarly but begin with a five year fixed rate.
Homeowners whose payments rise rapidly after rate resets can continue to make payments on the loan or refinance with a new loan. Lenders in many countries require borrowers to have at least 20 percent equity in their homes in order to refinance, so in places where home prices have fallen some homeowners cannot refinance 7/1 ARMs due to lack of equity. As with most 30 year mortgages, the payments for 7/1 ARMs cover the cost of loan as well as insurance and taxes due on the property.