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Compare 3/1 adjustable rate mortgages (ARM)

The benefits and drawbacks of this tricky mortgage product.

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If you’re planning to refinance or move within three years, a 3/1 adjustable-rate mortgage (ARM) could save you in interest. But after the first three years, your rates adjust annually — often to a higher interest rate. Weigh the benefits and risks of this type of loan.

What is a 3/1 ARM?

A 3/1 ARM is a hybrid loan product where the rate is fixed for the first three years, often at a low rate. After three years, a variable rate kicks in and adjusts annually according to the market — often to a higher rate.

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 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 ARM 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 payments 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.

Pros and cons

Pros

  • Lower initial rate.Generally, the initial interest rate of an ARM is lower than 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.

Cons

  • Market risk. After the fixed-rate period ends, the interest rate can rise, making your monthly payments more expensive.
  • Complexity. The structure of ARMs can be difficult to understand for many borrowers when considering the margin, caps, indexes and fees. Some 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.

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:

  • Rate. The interest rate is one of the most important indications of whether or not a mortgage is the best choice for you, as it determines your monthly payments. The advertised interest rate won’t take fees into account, so take a look at the comparison rate as well.
  • Prepayment penalty. This isn’t important for all borrowers, but some ARMs 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 to get the best rate for a 3/1 ARM

There are a few steps you can take to net a lower rate for any type of mortgage, including:

  • Improving your credit score. Focus on paying off high-interest loans and making on-time payments to increase your FICO scores over time.
  • Researching first-time homebuyer programs. Different states offer different programs for first-time homebuyers that could provide down payment assistance, tax breaks and decreased rates.
  • Paying discount points. This is an upfront fee that you pay your lender to reduce your mortgage rate. One discount point typically costs 1% of your loan amount and can lower your rate around a quarter of a percent, though the amount varies by lender.
  • Shopping lenders. Speak with multiple lenders and compare rates, fees and closing costs before deciding which one to go with.

Why should I consider getting a 3/1 ARM

A 3/1 ARM gives borrowers the flexibility of lower interest rates and monthly payments for the first three years. This feature of lower payments often allows homebuyers to qualify for a larger amount than they would with a traditional 30-year fixed loan.

Homebuyers who intend to move 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, you could have the option to refinance fixed-rate mortgage after three years.

3/1 ARM vs. 30-year fixed

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

If you know you’ll be moving in three years — or plan to refinance — a 3/1 ARM could free up some of your cashflow by providing lower payments. But if your plans change, you run the risk of rates spiking at the end of the first three years. A 30-year fixed provides stability throughout the life of the loan. Which one is right for you ultimately depends on your situation, future plans and risk tolerance.

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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