Definition: A 3 Year ARM is a loan with a fixed rate for the first three years that has a rate that changes once each year for the remaining life of the loan. Because the interest rate can change after the first three years, the monthly payment may also change.
A 3 year ARM, also known as a 3/1 ARM, is a hybrid mortgage. A hybrid mortgage combines features from an adjustable rate mortgage (ARM) and a fixed mortgage. The loan begins with a fixed rate for a specified number of years (in this case three), but then changes to an ARM with the rate changing once every year for the rest of the term of the loan.
An ARM is a mortgage loan that has an interest rate that adjusts, or changes, usually once a year. The benefit of an ARM is that it tends to give the borrower a lower interest rate initially. The risk is that the interest rate most likely will go up. The change in interest rate is tied to an index. An index is a published interest rate based on the returns of investments such as U.S. Treasury securities. The rates for these investments change in response to market conditions, so an index tends to track to changes in U.S. or world interest rates. An ARM is adjusted up or down based on the index it is associated with.
With a 3/1 ARM, the interest rate does not begin changing based on the index immediately. Your interest rate is fixed for the first three years of the loan with a 3 year ARM. After 3 years, the interest rate can change annually for the next 27 years or until the loan is paid off. The first number in the name 3/1 ARM indicates the number of years of the fixed period while the second number indicates the adjustment interval. An adjustment interval is the period between potential rate changes (in this case, one year).
Hybrid mortgages such as the 3/1 ARM tend to offer a lower initial interest rate than a fixed loan but a higher interest rate than a standard ARM. The borrower has the security of knowing what the monthly payments will be for the fixed period of the loan. With a 3/1 ARM, you know exactly what the interest rate will be for the first 3 years. After that, your interest rate, and therefore your monthly payment, could go up or down.
A 3/1 ARM could save you money on your monthly mortgage payment, at least at first. For example, let’s say you are purchasing a $200,000 house and putting down 20 percent. After borrowing $160,000 at a 7 percent interest rate, your monthly payment on a 30 year fixed rate mortgage would be $1,064.48 each month. A 3/1 ARM can get you into the same house but with lower initial monthly payments. With a 3 year ARM you may be able to start out with a 6.25 percent interest rate, therefore making your monthly payments $985.15 for the first 3 years of the loan. However, after the 3 year fixed period, the interest rate can change based on the index. Because of this, it is essential that you be sure you can still afford the monthly payments if interest rates go up.. Most 2/1 ARM’s will have a lifetime payment cap that limits how much the interest rate on your loan can rise.
If you plan to move or refinance prior to the end of the first 3 years of your mortgage, a 3/1 ARM may be right for you. You do need to be aware that some states allow prepayment penalties for hybrid arms. If you refinanced your home or sold it during the first 5 years of your loan, you may have to pay the lender a penalty fee. Find out from your lender the consequences, if any, of paying off the loan during the fixed period.
Weigh your options carefully when deciding on the mortgage product that is best for you.