What is a 3/1 adjustable-rate mortgage (ARM)?
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What is a 3/1 ARM?
A 3/1 adjustable-rate mortgage (ARM) is a type of home loan that has a fixed interest rate for an introductory period and then a variable rate once the introductory period ends. These loans typically have a 30-year term.
With a 3/1 ARM that has a 30-year term, the rate is fixed for three years and then adjusts annually for the following 27 years.
Another common mortgage is the 3/6 ARM, which adjusts every six months after the initial period.
When does a 3/1 ARM adjust?
When your 3/1 ARM adjusts is dependent on when you close the loan. For example, if you closed your loan on July 1, 2020, the first rate adjustment will happen on July 1, 2023. If you closed your loan on June 18, 2021, the first rate adjustment will happen on June 18, 2024.
When this adjustment occurs, the principal interest of your loan is recalculated going forward. The rate will be based on a particular index. Your lender will decide on the specific index when you apply for the mortgage. When it’s time for your loan to adjust, if the index goes down, so should your monthly payment. The opposite is also true: If the index increases, so should your monthly payment. There are multiple types of caps on how much the interest rate can rise over the life of the mortgage.
What index does the 3/1 ARM mortgage use?
For many years, these loans have been tied to either the yield on 1-year Treasury bills, the 11th District cost of funds index (COFI) or the London Interbank Offered Rate (LIBOR). However, LIBOR has been phased out in favor of a new index called the Secured Overnight Financing Rate (SOFR).
The mortgage rate will be the rate of the index, plus a stated margin. For example, in May 2022, SOFR reached 0.80 percent. If the margin is 2.75 percent, the loan rate would be the sum of the two, or 3.55 percent.
3/1 ARM vs. 5/1 ARM
The 3/1 ARM is similar to the 5/1 ARM. However, with a 5/1 ARM, the initial rate adjusts after the first five years rather than three years. Generally, the interest rate on the 5/1 will be a little higher than the 3/1, reflecting the added time the initial rate is locked in.
3/1 ARM vs. 7/1 ARM
The 7/1 ARM is similar to the 5/1 and 3/1 ARM. However, with a 7/1 ARM, the initial rate adjusts after the first seven years. Again, rates will be higher than the 3/1 or the 5/1. This loan can be a good choice for borrowers who know they want to move or refinance within seven years.
With all these loans, the rate resets every year after the initial fixed period based on the stated index plus a margin.
What are the pros and cons of a 3/1 ARM?
The primary benefit of a 3/1 ARM is that they typically carry lower interest rates than standard 30-year fixed mortgages, at least for the initial three years. During this time, you may be able to take advantage of a lower monthly payment.
A possible benefit of a 3/1 ARM is that your rate may decrease after the initial three years. However, it’s also a possible downside that your rate may increase after the initial three years.
And while it’s true that a lower interest rate rate during the first three years may help you afford a bigger monthly payment, that doesn’t necessarily mean it’s a smart idea. Regardless of the mortgage type, a common rule of thumb is that no more than 28 percent of your gross income should go toward your monthly mortgage payment. Use Bankrate’s home affordability calculator to see how much you can comfortably afford.
Correction, Feb. 10, 2023 3:36 pm ET: A previous version of this article incorrectly stated that all 3/1 ARMs have a 30-year term. A previous version of this article also incorrectly stated that the SOFR was 1.05 percent in May 2022. This article has been corrected to say that SOFR was 0.80 percent in May 2022. This article has been updated to clarify that most, but not all, have 30-year terms. This article has also been updated to include clarifying details on the pros and cons of a 3/1 ARM.