3/27 Adjustable-Rate Mortgage (ARM)

How a 3/27 Adjustable-Rate Mortgage (ARM) Works

Adjustable-rate mortgages 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 adjustable-rate mortgage, 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 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 it is based on.

3/27 Adjustable-Rate Mortgage Example

Say 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 Adjustable-Rate Mortgage (3/27 ARM)

The 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 Penalties

Borrowers should also be aware that adjustable rate mortgages, 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."

Is a 3/27 ARM a Good Investment?

A 3/27 adjustable-rate mortgage could be a good choice for you if you're looking for a loan with relatively low monthly payments for the first several years. That could make buying a home more affordable if your budget is already stretched or give you some extra cash to spend on home repairs, furnishings, or other purposes, compared with a more expensive loan.

However, you'll want to be reasonably certain that you'll be in a good position to refinance by the end of the initial, three-year period. That means, for example, that you'll have a strong credit score and a reliable source of income at that point.

A 3/27 adjustable-rate mortgage is not a good idea if there's a strong possibility that you won't be able to refinance (or sell the home) during those first three years and the new, adjustable-rate payments would be too much for you.

What Is a 3/27 Adjustable-Rate Mortgage?

A 3/27 adjustable-rate mortgage (ARM) charges a fixed interest rate for the first three years, followed by a variable interest rate for the remaining 27 years. Because it combines the features of a fixed-rate and an adjustable-rate mortgage, it is sometimes referred to as a hybrid ARM.

What Are the Advantages of a 3/27 Adjustable-Rate Mortgage?

A 3/27 adjustable-rate mortgage is likely to have a low interest rate for the first three years. But that rate can rise substantially starting in the fourth year.

Is a 3/27 Adjustable-Rate Mortgage Right for Me?

If you plan to sell the home or refinance it within the first three years, a 3/27 ARM might make sense for you. However, look for a 3/27 ARM without any prepayment penalties. Otherwise, a prepayment penalty could make it very costly to get out of the mortgage.