Lenders offer a variety of different mortgage loan options. One of the options is an adjustable rate mortgage, also know as an ARM, rather than a mortgage with a fixed rate. Each ARM has an introductory period where the rate is fixed and then an adjustment period, where the interest rate adjusts periodically depending on the loan.
3/1 adjustable rate mortgages have two significant time frames. First, the three represents the number of years the introductory interest rate lasts. Second, the one represents how often the interest rate adjusts after the introductory period ends. With a 3/1 adjustable rate mortgage, the interest rate changes once per year after the first three years.
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3/1 adjustable rate mortgages do not all have the same features. Adjustable rate mortgages can have a variety of caps to limit the changes to the loan. Some ARMs have periodic change caps, which limit the amount the interest rate can change each adjustment. For example, a 1 percent periodic cap on a 3/1 ARM would mean that the interest rate could not increase or decrease more than 1 percent after each year. A lifetime cap limits the amount the interest rate can change over the life of the mortgage. For example, a 4 percent lifetime cap on a 3/1 ARM that started at 6 percent would prevent the rate from going above 10 percent or below 2 percent.
Each 3/1 ARM is tied to an index interest rate that is used to calculate the new interest rate at each scheduled change. Common indexes include the London Interbank Offered Rate (LIBOR) and the Cost of Funds Index. A margin, which is an amount set by the bank based on your creditworthiness, is added to the interest rate index. For example, if your 3/1 ARM has a 3 percent margin and the interest rate index is 5.4 percent when the interest rate is scheduled to change, the new rate would be 8.4 percent.
The advantage of ARM mortgages is also the disadvantage: your interest rate will change without you having to take out a new loan. This is a significant advantage when interest rates fall because your mortgage rate will drop without you having to pay the closing costs of a mortgage refinance. However, if interest rates rise, your loan interest rate and monthly payment will increase.
Beware of ARM mortgages with low introductory rates because the interest rate will adjust to the market rate after the introductory period. According to the Federal Reserve, some lenders will offer a teaser rate, which is lower than the sum of the margin plus the interest rate index. However, this rate can rise significantly after the introductory period, which is just three years with a 3/1 ARM. You need to carefully consider how much higher payments would affect your ability to repay the loan because if you cannot make payment, you could lose your home due to foreclosure.