3/1 adjustable-rate mortgage

You need to understand what a 3/1 adjustable rate mortgage is. Here’s what to know

What is a 3/1 adjustable-rate mortgage?

A 3/1 adjustable-rate mortgage (ARM) is a 30-year mortgage product that carries a fixed interest rate for the first three years and a variable interest rate for the remaining 27 years. After the initial three-year fixed period, the interest rate resets every year.

Deeper definition

Lenders tie the variable interest rate for the 3/1 adjustable-rate mortgage to a stated index. Common indexes include the 11th Federal Home Loan Bank District cost of funds index, Libor and the maturity yield on one-year Treasury bills.

However, the index does not solely determine the new interest rate. Lenders also add a margin to the index. This margin stays the same throughout the life of the loan, while the index varies according to market conditions.

There are rules that dictate how much the interest rate can increase. Sometimes, there’s an annual limit, while other times there is a lifetime limit for the entire loan term.

The 3/1 adjustable-rate mortgage initially makes home ownership inexpensive, but once the rate starts to increase, payments can dramatically increase. Borrowers should fully understand how their payments will adjust and what their maximum payment will be.

3/1 adjustable-rate mortgage example

The 3/1 adjustable-rate mortgage appeals to borrowers who need to minimize expenses or expect to refinance the mortgage before the interest rate significantly increases.

For example, assume that you take out a $200,000 3/1 adjustable-rate mortgage with a three-year fixed interest rate of 3 percent. This results in a monthly payment of $843.21. After the three-year into period expires, the interest rate margin is Libor plus a 2 percent spread. If Libor is at 2 percent, adding the 2 percent spread provides a new interest rate of 4 percent. This increases the mortgage payment to $945.19.

Not sure if you should go with a fixed or adjustable-rate mortgage? Run the numbers using Bankrate’s convenient mortgage calculator.

More From Bankrate