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What is a 3-year ARM?

A 3-year ARM is a type of adjustable-rate mortgage where the interest rate is fixed for the first three years of the loan term. After that point, the rate adjusts periodically based on a financial index—such as the one-year Treasury rate, London Interbank Offered Rate (LIBOR), or the Federal Cost of Funds Index (COFI). There is also a predetermined margin, which serves as the lender's profit. The rate on a 3-year ARM may adjust annually, semi-annually, or even monthly, depending on the terms of the loan.

For example, if you take out a 3-year ARM with an initial interest rate of 5%, your rate will remain fixed at 5% for the first three years of the loan. After that, the interest rate may adjust up or down every year, based on the terms of the loan agreement.

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What is a 3/1 ARM?

A 3/1 ARM is a specific type of 3-year ARM where the interest rate adjusts each year. The “3” refers to the number of initial years with a fixed rate, and the “1” refers to how often — in years — the rate adjusts after that initial fixed-rate period. The loan is fully amortized after 30 years in most cases.

How does a 3/1 ARM work?

It's important to note that with a 3/1 ARM (or any type of adjustable-rate mortgage), your monthly mortgage payment could increase or decrease depending on what markets are doing. This means that your payments could go up if the interest rate increases, which could make it more difficult to afford your monthly mortgage payments.

That said, most ARMs come with caps that limit how much the interest rate can adjust each year. There are two types of caps:

  • Periodic caps, which limit how much the interest rate can adjust each year, and
  • Lifetime caps, which limit how much the interest rate can increase over the life of the loan.

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When should you consider a 3-year ARM?

Due to the short fixed-rate period and unpredictable payments later on, a 3-year ARM makes more sense for certain types of borrowers than others. It can be easy to be swayed by a low introductory rate, but it’s important to think about your long-term homeownership goals and financial situation before choosing this type of mortgage.

Situations when you might want to consider a 3-year ARM include:

  • You don’t plan to stay in your home long: If you expect to sell your home in the next few years, a 3-year ARM could be a good option. You can take advantage of the lower initial interest rate and sell the home before the interest rate adjusts.
  • You have a shorter time horizon for your mortgage: Similarly, if you plan to pay off your mortgage quickly, a 3-year ARM might make sense. Again, you can take advantage of that lower initial interest rate, and pay off the loan before the rate adjusts.
  • You expect your income to increase: If you’re growing in your career and expect to get a raise or promotion in the next couple of years, that could add extra assurance that you’ll be able to afford a higher mortgage payment if your rate goes up later on.

Historical 3/1 ARM rates

Historically, the interest rates for 3/1 ARMs have been lower than those for 30-year fixed-rate mortgages.

Sources such as the federal government don’t track the historical rates for 3/1 ARMs, but there are statistics available for 3-year ARMs in general.

According to real estate company Zillow, the interest rate of a 3/1 ARM has jumped about 4% over the past two years. For users with a credit score of 680 to 740, who made a downpayment of at least 20%, the average rate sits at 6.14% as of April 24, 2023. This is in contrast to around 3% in April 2021.’

Historically, a 3-year term sat at 14.25% in 1980 and increased to 18.75% in 1982 before trending down again. The average since 1980 sits at 7.80%.

How to get the lowest 3/1 ARM rate

Adjustable-rate mortgages are known for having already low initial rates. Still, you want to ensure you’re getting the lowest rate possible, since it will help you save money today and serve as a lower starting point if the rate adjusts upward in the future.

There are many factors that affect the rates you’re offered, but here are some of the best ways to qualify for a low rate on a 3/1 ARM:

  • Improve your credit score: Lenders typically reserve their best interest rates for borrowers with excellent credit. So be sure to pay your bills on time, minimize the amount of debt you owe, and avoid opening too many new credit accounts.
  • Shop around: Even with great credit, each lender will have its own standards for evaluating your application. Shopping around and comparing offers from multiple lenders can help you find the lowest interest rate for your situation. Make sure to focus on the APR, which includes both the interest rate and any fees associated with the loan.
  • Provide a larger down payment: Offering more money upfront reduces the level of risk the lender takes on, since you have more equity in the property. So if you have the extra cash, consider offering a larger down payment—especially if it allows you to avoid the added cost of private mortgage insurance (PMI), which is required on loans with less than 20% down.
  • Consider paying points: Points are an upfront fee paid to the lender to lower the interest rate on the loan. One point typically equals 1% of the loan amount. Paying points can help you lower your interest rate and save money over the life of the loan, but it also means paying more upfront costs. It’s important to do some math and figure out how long you need to stay in your home to reach the break-even point.

3/1 ARMs and taxes

The good news is that the interest on a 3/1 ARM (as well as any other type of mortgage) is often deductible on your tax return. To be eligible, the loan needs to be secured by your home, and the loan must have been used to buy, build, or improve your primary residence or another home you use for personal purposes. In order for rental properties to qualify, you must either live in the property 10% of the time it’s rented to tenants, or 15 days per year (whichever is more).

Keep in mind that if the interest rate on the ARM decreases, your monthly payment may decrease as well, resulting in less interest paid and a smaller tax deduction. On the other hand, if the interest rate increases, resulting in more interest paid, you might see a larger tax deduction.

Refinancing your 3/1 ARM

The process for refinancing a 3/1 ARM is the same for most other types of mortgage loan. And it can be a good option if you want to switch to a more stable and predictable home loan with a fixed interest rate.

Other possible reasons to refinance a 3/1 ARM include securing a lower interest rate than you’re currently paying, leveraging equity in your home to pull out cash, or changing the name on the mortgage.

Whatever the reason, be sure to compare refinancing offers just as you would for a new home loan.

ARM glossary

APR

APR stands for “annual percentage rate.” On a mortgage, it represents the annual cost of borrowing money to purchase a home, including the interest rate and any fees associated with the mortgage, such as points, origination fees, and closing costs.

Index

An index is a benchmark interest rate that is used by lenders to determine the interest rate on adjustable rate mortgages. An index represents the current market interest rate and is usually an average of rates on different types of loans or securities.

Rate cap

An ARM often comes with rate caps, which are limits on how much the interest rate can change over the life of the loan. There are two types of rate caps: periodic caps and lifetime caps.

Buydown

A buydown is a way to lower the initial interest rate on a mortgage loan by paying additional upfront fees or points. Essentially, a buydown is a type of prepaid interest that allows you to pay a lower interest rate for the first few years of the loan.

Initial period

The initial period on an ARM is the period of time at the beginning of the loan during which the interest rate is fixed. The length of the initial period can vary depending on the loan program, but is typically either one, three, five or more years.

Adjustment period

The adjustment period on an ARM is the period of time between interest rate adjustments. After the initial period ends, the interest rate on the loan will begin to adjust periodically (typically, once per year).

Points

Points, also known as discount points, are an upfront fee paid to the lender at closing in exchange for a lower interest rate on a mortgage loan. One point typically equals 1% of the loan amount, and paying points can lower the interest rate on the loan by a certain amount, usually around 0.25% per point.

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About the Author

Casey Bond

Casey Bond

Freelance Contributor

Casey is an award-winning personal finance writer who has held roles as Money reporter at HuffPost, executive editor at Student Loan Hero, and editor-in-chief at GOBankingRates. Casey’s work has also appeared on Yahoo! Finance, Money.com, Fortune, MSN, Business Insider, U.S. News & World Report, Forbes Advisor, and more.

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