A 3/1 ARM is an adjustable rate mortgage that holds at a low monthly payment for three years and then adjusts to a higher interest rate based on two calculation values: the index and the margin. The index is a value taken from a well known money market product such as the one year Treasury bill. The margin is the number of percentage points (usually between two and three) that are tacked onto the index to produce the interest on your loan for the next twelve months. The source of the index and the margin number are both defined in the mortgage contract. The interest rate is adjusted annually.
The average introductory interest rate for 3/1 ARMs on this particular day in May of 2020 is 5.52%. That means the mortgage payments for the first three years of a $300,000 thirty year loan will be $1,707. We’ll assume that the index for this loan is the one year Treasury bill, which on the day this is being written has an interest rate of 4.9 percent. Our second assumption is that the margin for this 3/1 ARM is 2 ˝ %. That means that the interest rate on the thirty year loan will rise to 7.4 at the beginning of year four.
At that interest rate your monthly payment will rise to about $2,000 and will adjust annually, subject to an annual cap, which is usually a figure in the neighborhood of 7 or 8 percent per year. Seven percent of the year four interest rate (7.4%) is just over half a percentage point at .51%. So the worst case scenario for year five on this loan is an increase of 7.4% plus.51%, which equals 7.91%.
Most ARMs have a maximum cap for the interest rate, put in place in case some sort of turmoil develops in the economy and loan indexes shoot up. If the maximum interest rate on this particular 3/1 ARM is 12%, the most your payments can ever be is $2472.
Many people find themselves with adjustable rate mortgages because they don’t qualify for a fixed rate mortgage. Others see ARMs as a method to maximize their buying power by keeping their initial monthly debt low. Monthly debt service is a critical benchmark for most lenders; most won’t consider a mortgage if the mortgage payment drives debt service beyond 40% of household monthly income.
A 3/1 ARM is probably a good choice for home buyers that expect an increase in household income over the next few years or that need to spend a significant amount furnishing the house or landscaping it or remodeling some outmoded portion of the property. The year four increase is going to be about $300; that’s a figure that can be included in the household budget with careful planning and disciplined execution. The worst case scenario – an extremely unlikely occurrence – is still within range, even if household spending has to go into emergency mode. A 3/1 ARM can be the right choice for some buyers – especially young buyers – who have growing careers.