how a 3 27 arm works
adjustable rate mortgages arms are a type of home loan in which the interest rate applied to the outstanding balance varies throughout the life of the loan with an arm the initial interest rate is fixed for a period of time after that the rate resets periodically at yearly semiannual or even monthly intervals arms differ from fixed rate mortgages the other primary mortgage type which charge a set rate of interest that remains the same for the entirety of the loan 3 27 arms are a kind of hybrid for the first three years they have a fixed interest rate which is generally lower than the current rates on 30 year conventional mortgages but after that and for the remaining 27 years of the loan their interest rate will fluctuate based on a benchmark index such as the yield on one year u s treasury bills the lender also adds a margin on top of the index to set the interest rate that the borrower will actually pay the total is known as the fully indexed interest rate this rate is often substantially higher than the initial three year fixed interest rate although 3 27 arms usually have caps on how quickly they can increase typically the interest rate on a 3 27 arm won t increase more than 2 per adjustment period which can occur every six or 12 months that means the rate can increase by two full percentage points not 2 of the current interest rate so for example the rate might go from 4 to 6 in a single adjustment period there might also be a life of the loan cap set at 5 or more in that case the interest rate on a mortgage that started at 4 might go no higher than 9 regardless of what happens with the index on which it is based 3 27 arm examplesay a borrower takes out a 250 000 3 27 arm at an initial fixed rate of 3 5 for the first three years their monthly mortgage payment will be 1 123 then let s assume that after three years the benchmark interest rate is 3 and the bank s margin is 2 5 that adds up to a fully indexed rate of 5 5 if the borrower still has the 3 27 arm and hasn t refinanced into a different mortgage their monthly payment will now be 1 483 an increase of 360 to avoid payment shock when the interest rate begins to adjust borrowers with 3 27 arms should aim to refinance the mortgage within the first three years risks of a 3 27 armthe most serious risks for borrowers with a 3 27 mortgage are that they won t be able to refinance their loan before the adjustable rate kicks in and that interest rates will have shot up in the meantime that could happen if their credit score is too low if their home has fallen in value or simply if market forces have caused interest rates to rise across the board in that event they would be stuck with the adjustable rate which could mean considerably higher monthly payments as in the example above arm prepayment penaltiesborrowers should also be aware that arms including 3 27 mortgages may carry prepayment penalties which can make refinancing costly and defeat the purpose of taking out an arm with the intention of switching to a different loan in a few years the consumer financial protection bureau cfpb suggests that borrowers check the lender s truth in lending act disclosure for any prepayment penalties before they sign a contract remember many aspects of the loan are negotiable the cfpb notes ask for a loan that does not have a prepayment penalty if that is important to you if you don t like the terms of a loan and the lender won t negotiate you can always shop around for a different lender with terms that better suit your needs 