Compare 3/1 adjustable rate mortgages

The ups and downs of this tricky mortgage product.

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If you’re planning to refinance or move within three years, you may be able to save with a 3/1 ARM (adjustable rate mortgage). But, as with any financial product, there are some drawbacks to this type of mortgage. After the first three years, your mortgage will begin to adjust once per year — often to a higher interest rate.

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What’s a 3/1 ARM?
fixed interest rates

A 3/1 ARM is a hybrid mortgage product, of sorts. The rate is fixed for the first three years of the loan. After three years, a variable rate kicks in and adjusts annually from there.

With a 3/1 ARM, your monthly mortgage payments will be lower initially, but will likely increase after the three years pass. This type of loan allows homebuyers to pay a lower initial mortgage, sometimes qualifying for a home they might not otherwise qualify for.

Some homeowners choose to refinance to a more stable, fixed-rate mortgage before the adjustable rate period begins. Others will sell their home and move. Be aware, though, that selling your home and paying off your ARM — or refinancing — before the end of the three-year period could result in a penalty fee.

How does it work?

A fixed-rate mortgage is designed to protect you against rising interest rates. Once you lock in a rate with your lender, it stays the same for the life of the loan. A variable rate fluctuates with the market. If the rates go up or down, so do your payments.

A 3/1 ARM combines both of these scenarios into one and are often a good fit for those who plan on moving or refinancing before the fixed rate turns into an adjustable one.

Who would benefit from getting a 3/1 ARM?

A 3/1 ARM allows you to make lower monthly payments with an initial lower interest rate for the first three years. This feature of lower payments allows homebuyers to qualify for a larger mortgage than they would with a traditional 30-year fixed mortgage.

Homebuyers who intend to move and/or trade up in three years are ideal candidates for a 3/1 ARM. If you don’t plan on moving but would like to take advantage of the lower interest rate that a 3/1 ARM provides, there’s always the option to refinance after three years.

What types of 3/1 ARMs are available?

There is more than one type of adjustable rate mortgage, each with different features:

Hybrid ARM

This loan is a mix of fixed-rate period and adjustable-rate period. The interest rate is fixed for an initial period — three years in the case of a 3/1 ARM — and becomes adjustable after that until the loan is paid off.

Interest-only (I-O) ARM

An I-O loan allows you to pay only the interest portion of your loan for a set period — normally three to 10 years. This allows you to make smaller monthly payments over an introductory period, as you’re only paying the interest portion and not the principal. After this time, your monthly payment will increase as you start paying back both the principal and interest.

Payment-option ARM

This type of ARM allows you to select a particular payment option each month. Options can include principal and interest, interest-only or minimum payments. A minimum payment may be less than the amount of interest due that month. Keep in mind that a minimum payment can increase the amount you owe on the loan.

How to compare 3/1 adjustable rate mortgages

A 3/1 ARM can be compared using the same factors as a more traditional mortgage, with a few additional points to consider:
3 year fixed rate home loans

  • Rate. The interest rate is one of the most important indications of whether or not a mortgage is the best choice for you. It will have a large say in how expensive your monthly payments will be. Also keep in mind that the advertised interest rate will not take fees into account, so take a look at the comparison rate as well.
  • Prepayment penalty. This won’t be important for all borrowers, but some adjustable rate mortgages come with a penalty if you sell or refinance your home within the first three years.
  • Closing costs. Compare the closing costs, which can include appraisal, credit report, home inspection, origination fee, title insurance, survey fee, property tax and others.
  • Other features. This can include interest-only payment options. Interest-only allows for lower initial payments, but you won’t be paying down the principal of the loan.

How do 3/1 ARM rates compare to 30-year fixed rates?

Compared to a traditional 30-year mortgage, a 3/1 ARM will have initial lower payments, with a lower interest rate for the first three years. A 3/1, interest-only ARM will come with even lower monthly payments. But you won’t be paying down the principal of your loan.

Benefits of a 3/1 ARM

  • Lower initial rate. Generally, the initial interest rate of an ARM is lower compared to a fixed-rate mortgage.
  • Qualify for a larger amount. Since the initial payment is often lower compared to that of a fixed-rate mortgage, an ARM can maximize your home buying power by making it easier to qualify for a larger amount.
  • Rate cap protection. Many ARMs have an interest rate cap, which places a limit on how much the interest rate can increase.

Drawbacks of a 3/1 ARM

  • Market risk. After the fixed-rate period ends, the interest rate can rise. This could make your monthly payments more expensive after the initial period ends.
  • Complexity. The structure of ARMs can be difficult to understand for many borrowers when considering the margin, caps, indexes and fees. Less-than-savvy borrowers may find it difficult to effectively compare ARMs.
  • Penalty fee. If you sell or refinance your home before the first three years, you could be subject to a penalty fee.

Bottom line

3/1 ARMs offer lower initial payments and the ability to qualify for a larger mortgage. But if you don’t sell your home or refinance after the first three years, you’re subject to a possible rate increase.

Buying a home is complicated, but getting the best mortgage can save you thousands over the life of the loan.

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