3-Year Adjustable-Rate Mortgage (ARM) — What You Need to Know

If you’re looking to take out a home loan for as low an interest rate as possible before refinancing or moving home, a 3-year adjustable-rate mortgage (ARM) may tick many boxes. These mortgages often offer a lower interest rate than fixed-rate mortgages for an introductory period of three years, after which you can switch to another home loan.

However, they do come with their risks and considerations. To help you decide whether a 3-year ARM is right for you, we’ll explain how they work, the various types, an example, and the pros and cons. 

What is a 3-Year Adjustable-Rate Mortgage?

A 3-year adjustable-rate mortgage (ARM) is a type of home loan that features a fixed rate for the first three years, followed by a rate that lenders regularly adjust in line with market conditions. 

This is where the “adjustable rate” part of their name comes into play. In contrast, fixed-rate mortgages maintain the same interest rate for the entire loan term.

Therefore, once the initial three-year introductory rate is over, a three-year ARM could have a loan term of anywhere from five to thirty years.

3-year ARMs are less common than ARMs with longer loan periods, such as 10/1 ARMs. However, the shorter loan term may appeal to those who want to secure the lowest interest rate possible or who plan to move home or refinance in the short term.

How 3-Year Adjustable-Rate Mortgages Work

The frequency of rate adjustments in an adjustable-rate mortgage may differ. Most commonly, adjustments take place every year. These mortgages are known as a 3/1 ARM, with the 1 referring to one year and the 3 referring to the three-year introductory period. 

Less commonly, you may come across adjustable-rate mortgages that undergo adjustments every six months. These are known as 3/2 ARMs.

Other than the adjustment period, they work the same as other mortgages, with the following key elements:

• Interest rate. An annual percentage rate (APR) that expresses how much the borrower pays. It depends on factors like credit score, location, and market conditions.
• Loan term. The length of the mortgage term, in this case, is three years.
• Down payment. A borrower's upfront payment toward a house usually amounts to at least 10% of the purchase price.
• Loan principal. The value of the property’s price minus the down payment. This is the total amount the borrower pays back.

Understanding Adjustment Periods

While borrowers can’t predict how much their interest rate will fall or rise following the adjustment period, lenders do have a few checks in place:

• Initial adjustment cap. Dictates how much an interest rate can change after its first adjustment period.
• Periodic adjustment cap. Dictates how much an interest rate can change after each adjustment period.
• Lifetime cap. Dictates how much an interest rate can change over the total loan term. 

These set a ceiling on the changes borrowers can expect, providing some degree of stability.

Ultimately, mortgage companies decide how much to raise (or decrease) interest rates based on the overall market conditions. They use an index or benechmark, such as the London Interbank Offered Rate (LIBOR) or Secured Overnight Financing Rate (SOFR).

3-Year ARM Example

Let’s take the example of a borrower who purchases a house for $350,000 with a down payment of $35,000. This leaves a loan principal of $315,000, which we can use to work out the monthly payments.

Assuming a 5% interest rate, the principal and interest payments alone would be $1,691 per month—but we’re not finished yet.

Because this borrower has placed a deposit of 10%, they will also need to pay private mortgage insurance (PMI) each month since this applies to down payments below 20% only.

Plus, the mortgage would require monthly property tax and insurance payments of roughly $583 (according to US Bank estimates).

This brings the total monthly payments to $1,691 + $583 + $255 = $2,529 for the initial three years of the mortgage.

Once the initial introductory period is over, interest rates could rise. Let’s say there’s an interest rate cap of 6% in place, which ensures that the 5% interest rate cannot rise higher than 11%.

In this case, the maximum monthly payment would be $2,860.80.

Types of 3-Year ARMs

Not all 3-year ARMs are identical. Below are a few types to be aware of.

Non-Conforming ARMs

Most 3-year ARMs are conforming loans, which means they comply with Fannie Mae and Freddie Mac's lending criteria. These loan types are the most common and tend to have the most favorable terms.

However, an alternative is non-conforming loans. These have alternative requirements, such as allowing borrowers to put down lower down payments and borrow more money. Although 3-year ARMs may be available in this form, they are rare.

Government-Backed Loans

Many borrowers find it challenging to get onto the property ladder due to strict requirements regarding the down payment, credit history, and financial profile. Government-backed loans aim to ease these requirements by helping borrowers and promising to cover costs if they can’t. 

This gives mortgage lenders the confidence to offer loans to those who may not be able to get them otherwise or offer more favorable terms than those available elsewhere. The following government-backed loans may be available as ARMs:

• USDA loans — don’t require a down payment 
• VA loans — don’t require a down payment
• FHA loans — require a down payment of just 3.5%

Pros and Cons of a 3-Year ARM

Is a 3-Year ARM a Good Idea?

For many borrowers, a 3-year ARM is a good choice. This is especially true for those who don’t plan to stay in their house for more than three years because they can enjoy lower interest rates and payments during this time and then refinance to another deal later.

It may also suit those who expect to earn more in the future or who can afford to make extra payments during the low-rate introductory period.

On the other hand, they’re not an excellent option for those who want to stay in a home over the long run or have a weaker financial profile. To qualify for a 3-year ARM, you may need a strong credit score and a healthy down payment. 

If you’re unsure whether a 3-year ARM is right for you, it may be worth discussing your options with a mortgage professional or financial planner for personalized advice. They can help you compare 3-year ARMs with other options and understand the worst-case scenario of taking on the loan. 

Consider a 3-Year ARM If: 

• You’re comfortable with greater risk. Not knowing whether interest rates will be higher or lower after three years is more risky than many borrowers will be willing to accept.
• You’re planning to move or refinance after five years. This removes the significant risk component of an ARM and allows borrowers to take advantage of greater flexibility.
• You’re confident about your future income growth. Borrowers with a solid financial profile (and expect it to remain as such for the foreseeable future) will likely be more prepared to take on the risks of a 3-year ARM.

Is Now a Good Time for a 3-Year ARM?

You can keep up with average daily mortgage rates for 15-year and 30-year fixed-rate mortgages on FreeRateUpdate, which you can compare with quotes for ARM loans. We post the latest rates every day, Monday to Friday.

FAQs

What is a 3/3 ARM?

A 3/3 ARM has an interest rate that adjusts every three years. It’s less common than a 3/1  ARM, but some lenders offer this loan type, and it may suit those who want more rate stability.

Should I Choose a 3/1 ARM or 5/1 ARM?

The choice between a three-year or five-year ARM depends mainly on risk appetite and plans. A 3/1 ARM is better for those who want to move more quickly and are prepared to take on more risk, while a 5/1 ARM suits more conservative borrowers.

Can I Get a 3-year ARM with a Low Credit Score?

Typically, securing an ARM with a lower loan term, like three years, requires a good credit score. However, opting for a government-backed ARM makes this process easier.