7/6 ARM: Is it the best option for you? How does it work?

Most home buyers want a simple and predictable mortgage loan like the 30-year fixed.

But some buyers look beyond this obvious choice in search of more savings and flexibility.

An adjustable-rate mortgage, such as a 7/6 ARM, can save money when borrowers know how to use these loans to their advantage.

What Is a 7/6 ARM?

Compared to a 30-year fixed-rate mortgage, a 7/6 ARM can usually lock in a lower interest rate. This lower rate stays in effect for the first seven years of the loan's term. Then, once the seven-year introductory rate expires, the mortgage rate will change every six months.

Each rate change could increase or decrease the loan's interest rate, depending on market conditions at that time.

Of course, as the rate changes, so will the loan's monthly payment, making the 7/6 ARM less predictable than other loan types, including a 30-year fixed loan whose rate and payments stay the same.

What determines your adjusted rate

A 7/6 ARM's rate will be tied to an index rate such as the Cost of Funds Index (COFI), or the Secured Overnight Financing Rate (SOFR).

To this index rate, the lender will add its own margin rate.

So, if your ARM's index were 5 percent at the time of the rate change and the lender added a 2 percent margin, your new rate would be 7 percent.

The size of your lender's margin will depend a lot on your credit score and debt-to-income ratio. The best qualified borrowers usually pay smaller margin rates.

Rate caps protect you from dramatic increases

Modern adjustable-rate mortgages, like the 7/6 ARM, now include rate caps that limit how far the loan's rate and payment can climb.

These caps work in three ways:

• By limiting the initial adjustment amount
• By capping each subsequent adjustment
• By setting a lifetime maximum increase over your starting rate.

For example, a 2/1/5 cap would limit the loan's first rate increase to a 2-percent jump. Each adjustment after the first change would be capped at 1 percent. The rate could not increase by more than 5 percent over the life of the loan.

A mortgage calculator can model different rate scenarios and see how potential adjustments might affect your monthly payments.

....in as little as 3 minutes – no credit impact

How does a 7/6 ARM work?

The numbers tell the story: A 7/6 ARM offers a fixed rate for seven years followed by rate changes every six months.

These loans work particularly well for buyers who know they'll sell or refinance their home within seven years. Selling or refinancing would eliminate the 7/6 ARM before its rate has a chance to change.

This strategy lets the homeowner benefit from a lower rate without facing the trade-off, a rate that changes every six months.

Interest rates during the fixed period

During the initial seven years, your 7/6 ARM functions like a standard fixed-rate mortgage, but with a key advantage: a lower interest rate.

Lenders typically offer rates that run 0.25 percent to 0.75 percent below the fixed rate on the same home. This translates into noticeable monthly savings.

Paying less in interest each month can also grow equity in the home more quickly.

What happens after 7 years

When the initial rate period expires, the 7/6 ARM enters its adjustable phase. During this phase, the loan's interest rate changes every six months to align with current market conditions.

This adjustment phase continues for the remaining 23 years of the loan term.

Interest rate caps protect you

As we mentioned above, adjustable-rate mortgages include rate caps to protect consumers:

— Initial adjustment cap: Limits how much your rate can increase at its first adjustment

— Periodic adjustment cap: Caps rate changes for each subsequent adjustment

— Lifetime cap: Sets the maximum rate increase over the entire loan term

A typical 7/6 ARM might come with a 5/1/5 cap, meaning the rate won't change by more than 5 percent when the intro rate expires, by more than 1 percent at each six-month interval, and by more than 5 percent for the life of the loan.

7/6 ARM pros and cons

The best candidates for a 7/6 ARM can benefit from the loan's pros without facing many of its cons.

Advantages of a 7/6 ARM

— Lower initial interest rates: 7/6 ARMs typically start with rates 0.25 to 0.75 percent below comparable fixed-rate mortgages. For a $400,000 loan, this translates to $50-150 less per month during the first seven years, potentially saving as much as $12,600 over the fixed period.

— Built-in rate protection: Interest rate caps limit how much your rate can increase. Even if market rates soar, your 7/6 ARM includes caps on initial adjustments, periodic changes, and lifetime increases, preventing excessive payment shock.

— Flexibility for short-term homeowners: ARMs work well for borrowers who plan to sell or refinance within the first seven years. These borrowers benefit from the lower interest rate without experiencing any adjustments.

— Potential for rate decreases: Most borrowers worry about owing too much after an ARM's rate changes, but the opposite could happen. Rates could go down after the seven-year intro rate expires.

Disadvantages of a 7/6 ARM

— Payment uncertainty after year seven: Even with rate caps preventing an ARM from going completely off the rails, a 7/6 ARM's payment could go up by a couple hundred dollars depending on market conditions. This uncertainty still turns off a lot of buyers.

— Complexity compared to fixed-rate loans: With a fixed-rate loan, borrowers never have to think about index rates, margins, and adjustment caps. ARM borrowers need to pay more attention to these numbers.

— Potential prepayment penalties: Some lenders may still charge fees for paying off an ARM too soon.

— Rate floors limit downside protection: While your rate can decrease, it will never fall below the margin set by your lender, regardless of how low market rates drop.

— Risk for long-term homeowners: If you keep the loan longer than planned, you may be forced to refinance and pay closing costs to avoid a rate increase.

Use a mortgage calculator to model different rate scenarios and determine if the initial savings justify the potential risks for your situation.

....in as little as 3 minutes – no credit impact

7/6 ARM requirements

Can you qualify for a 7/6 ARM? Here are some general rules to know about:

— Credit score: A FICO of 620 is typically high enough to qualify for a 7/6 ARM. WIth a higher credit score, you may get a lower margin rate, allowing more savings.

— Debt-to-income ratio: Lenders cap your DTI at 50% or lower, meaning monthly debt payments cannot exceed half your gross income.

— Down payment: Most 7/6 ARMs require a minimum 5 percent down payment, allowing you to borrow up to 95 percent of the home's value. This loan-to-value ratio of 95% gives you flexibility while protecting the lender's investment.

— Income verification: Lenders need to know your income is stable and likely to continue so you can afford the monthly payments.

— Cash reserves: Some lenders require borrowers to have two to six months of mortgage payments in savings. For borrowers with more debt, this will be especially important.

Remember that meeting a loan's minimum requirements doesn't guarantee approval or the best terms. Stronger qualifications—higher credit scores, lower DTI ratios, and larger down payments—unlock better rates for this adjustable-rate mortgage.

When should you consider a 7/6 ARM

The 7/6 adjustable rate mortgage works best for buyers with:

— Short-term homeownership plans: You're confident about selling within seven years. Maybe you're buying a starter home, expecting a job transfer, or planning to upgrade once your family grows. The 7/6 ARM lets you pay lower rates while you own the home.

— You want to refinance: You plan to refinance before year seven arrives. Be sure to plan for the costs of refinancing which usually run about 3 percent of the loan amount.

— You'll earn more money later: If your career path includes a big bump in earnings over the next few years, a 7/6 ARM could help you afford a more expensive home now. Later, once you start earning more, you can refinance.

— Market timing considerations: Some borrowers like to forecast future mortgage rates and time their ARMs to benefit from future conditions. There's no guarantee rates will behave as expected, though.

Is a 7/6 ARM right for you?

The 7/6 ARM won't fit every home buyer's needs. It's a niche product that can help some buyers get even more out of their real estate investment.

Getting a mortgage pre-approval can help borrowers decide between a standard 30-year fixed-rate loan and a more nuanced loan like the 7/6 ARM.

Better's pre-approval process can show your homebuying power within three minutes.

....in as little as 3 minutes – no credit impact