The 7-Year Mortgage: Take It or Leave It?

by Julie Rains on 4 August 2011 7 comments
Photo: Sanjoy Ghosh

My credit union has been promoting a seven-year mortgage. This type of loan could be perfect for someone who needs to pay off a mortgage quickly, or so I thought. But then I found out that there are many types of seven-year mortgages. Oddly, many have 30-year terms, and at least one type could easily put homeownership at risk.

You’ll have to read the fine print of your mortgage contract to scrutinize its terms, but most fall into the following categories.

1. The 7-Year, Fully Amortizing Loan (Paid Off in 7 Years!)

This type of loan is just what I imagined it to be. The schedule of payments is compressed so that the loan balance is paid within seven years. My credit union offers this home loan as a first mortgage only.

It seems perfect for the borrower who wants to 1) get a low rate and 2) match the loan payoff with the timing of a major lifestyle change, such as the start of a new business or retirement. (See also: What's faster for mortgage payoff: $100/month extra or 1 payment/year extra?)

2. Interest-Only for 7 Years, Then Fully Amortizing Loan (Paid Off in 30 Years)

The payments are relatively low for starters, as you will pay only interest during the first seven years. But your loan balance remains the same during this time, even if you make all the payments according to schedule.

After seven years, your payment will be adjusted to amortize the loan over the remaining term (typically 23 years). If you signed up for an adjustable rate mortgage (ARM), then your interest rate will reset also. The result could be a hefty monthly increase.

This type of loan could be the most expensive in terms of interest paid.

3. 7/2 — Fixed Rate for 7 Years, Adjustable Rates for Subsequent Years (23-30)

This ARM starts with a fixed rate with a stable monthly payment for seven years. After the initial term, the interest rate resets at regular intervals (every two years) and the monthly payment is recalculated.

ARTICLE CONTINUES BELOW

4. 7/23 — Balloon/Reset Mortgage

The balloon/reset mortgage is the kind that could be dangerous.

The first seven years are uneventful, as the interest rate is fixed and monthly payments stay the same.

But at the end of seven years, the entire balance is due unless certain provisions are met. According to Freddie Mac, these requirements usually include:

  • You're still the owner and occupant of the home.
  • You've paid your mortgage on time for at least a year prior to the balloon note maturity date.
  • You have no other liens against the property.
  • You've satisfied any other conditions of the reset.

If you qualify for the reset, then a new monthly payment is calculated and the loan balance is amortized over the remaining term. (A borrower could also refinance the loan but this scenario is not represented in the downloadable amortization schedule).

If you don't qualify for the reset (and are unable to refinance the mortgage), then you will need to pay the outstanding balance (that is, make a balloon payment) at the end of seven years. Failure to make this payment can trigger foreclosure, so be careful with this type of mortgage.

Downloadable Spreadsheet

I built a spreadsheet to illustrate how these mortgages work. You can see how payments are calculated and how borrowed amounts and outstanding loan balances are amortized over the term of the loan. The total interest paid is calculated for each loan type so that you can see the impact of various loan structures on total cost.

To customize the spreadsheet, download the file, then enter your loan balance, starting interest rate and interest rate caps (these cells are in orange). Note that I have established rate caps and time frames that seem reasonable; you may need to refine the spreadsheet for your own mortgage.

Have you considered a seven-year mortgage loan? What made you decide to take it or leave it?

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darcie

We haven't ever considered a 7 year loan, though we did start out with a 5 year ARM. We've since refi'd to a 30 year - as we've been in our house 10 years already...now I struggle with - do I stay or do I go now???

We pay extra on the principle every month...with the intention of being done in 15 years...(doesn't make sense to refi again because of the outrageous fees!) ~ I'd love a new home...but starting over 10 years in? ugh...

Guest's picture
Lonelle

This is one of the most helpful articles I have read lately!! I am getting ready to purchase a house in January and I had never heard of the 7 year loan!! I think this would work perfect for my family!! Thank you!!

Guest's picture

I've never even heard of most of these. Good to know.

Guest's picture
Paul S.

Hi Julie, I am 3 years into a 30year mortgage. My balance is $270,000 with an interest rate of 5.125%. My monthly payment is $1547. I pay $800 every two weeks (set up free through my mortgage company). I was thinking about refinancing the balance just for a lower rate. This payment makes my budget pretty tight and in approx. 11 years my monthly income will be decreasing by $1000 per month. I was wondering what you think the best strategy would be right now, a 5/2 arm, refi to another 30yr fixed at a lower rate, 15 yr fixed at a lower rate, etc...

Julie Rains's picture

Hi Paul, sorry to be slow in getting back to you. I am not great at guessing the answer but know how to run the numbers. Before you commit to anything, it would make sense for you to look at an amortization schedule comparing your present situation to different scenarios.

But in general, the 5/2 may not be a great idea for you because you can't be certain what the interest rate will be when you refinance; obviously if rates increase a lot, then you may not be able to afford the payment. If you kept up the current rate of payments, you would still have a balance of about 170K at the end of 5 years (I might recommend that route if you could pay off the loan in 5 years time though).

The other options to refinance to either a 15 or 30 year loan would be good ones, if you could get a low rate like 3% or 3.75%. You could still pay aggressively (making the $800 payment every other month) but with the lower rates you could pay off the loan in a bit less than 15 years for the 15-year loan and about 16 years for the 30 year loan.

When your income drops, however, it may be difficult to pay the mortgage but that should be more doable with the 30-year loan; of course, then you wouldn't be able to pay extra so your loan payoff will be extended. So, it looks like you may need to find a way to replace that income between now and 11 years. Rather than paying off the loan, you may need to set aside money so that you can make the monthly payment.

So, it looks like refinancing to a lower rate makes sense. But take a look at David's article on refinancing:

http://www.wisebread.com/3-hidden-dangers-of-refinancing-your-mortgage

Guest's picture

I guess I'll ask what I thought was the obvious question: Why not just get a 15-year mortgage and pay double payments? You are essentially making a 15-year mortgage a 7.5-mortgage by doing that. Plus, if disaster strikes, you can pay your regular payment and not risk losing the house.

Julie Rains's picture

If you are close to retirement (or have some specific 7-year goals), a 7-year mortgage may make sense to pay off a small mortgage, perhaps one that you have refinanced or that you have a lot of equity in b/c of a recent sale of another house. You could get a 30-year mortgage and pay aggressively in 7 years rather than 15; basically, you are aligning your mortgage pay-off with other life and financial goals.