A 3/1 ARM (adjustable-rate mortgage) is a type of mortgage that is very commonly offered today. If you are considering this type of mortgage, you will want to make sure that you understand exactly what is involved with it. Here are the basics of the 3/1 ARM.
Fixed Interest Period
With this type of mortgage, you will have three years of fixed interest. During this period, you will have a fixed mortgage payment every month. During this time, you will not have to worry about what interest rates are doing in the market because it will not affect your monthly payment.
After the initial three-year period is up, the loan will convert to an adjustable-rate mortgage. At that time, your interest rate will be recalculated at the beginning of the year. This will provide you with a new monthly payment for that particular year. For a certain number of years, your monthly payment will be recalculated at the beginning of the year.
How Interest Rate Is Determined
With the 3/1 ARM, your interest rate is going to fluctuate from one year to the next. Your interest rate will be tied to a particular financial index that will move up and down. In many cases, your interest rate will be tied to the one-year Treasury rate. This means that if the Treasury rate goes up over the course of the year, your mortgage interest rate is going to go up as well. This will result in a larger monthly payment for you over the course of that year.
Interest Rate Caps
With most adjustable-rate mortgages, you will have an interest rate cap that applies. This means that your interest rate will not be able to increase by more than a certain amount from one year to the next. For example, the adjustable-rate mortgage might allow your interest rate to increase only by a maximum of 2 percent every year. On top of that, the rate will be adjustable for only the first five years after the initial three-year fixed rate is up. This means that after eight years, your interest rate would be fixed for the remainder of the 30-year mortgage. Each adjustable-rate mortgage will be different, but most of them will have this type of feature.
You should also be aware of a phenomenon known as negative amortization. This occurs when the monthly payment is less than the interest that is accruing on the loan. When this happens, the interest that is not paid will be added to the balance of the loan. This is essentially increasing the loan amount every month. While this does not happen with every adjustable-rate mortgage, it is something for you to be aware of.
If you plan on using a 3/1 ARM, you should use caution. After the initial three-year period is up, your payment could rise substantially. If you plan on being in the home for an extended period of time, you might want to consider going with another option that does not carry as much risk.