What Does a 3/6 Adjustable-Rate Mortgage Mean?
Understand the 3/6 adjustable-rate mortgage. Learn how this unique loan structure determines your interest rate and future monthly payments.
An Adjustable-Rate Mortgage (ARM) is a home loan where the interest rate can change over time, unlike a fixed-rate mortgage. This variability means monthly payments may fluctuate throughout the loan’s duration. Understanding the specific structure of an ARM, such as a 3/6 ARM, provides clarity on how these fluctuations are managed and their impact on financial planning.
Understanding Adjustable-Rate Mortgages
Adjustable-Rate Mortgages are distinct from fixed-rate mortgages because their interest rate is not constant for the entire loan term. Instead, the rate is subject to periodic changes based on market conditions. This adjustment occurs at predetermined intervals after an initial period during which the interest rate remains fixed.
An ARM’s interest rate can move both upward and downward. This means initial payments might be lower than a comparable fixed-rate mortgage, but future payments could increase if market rates rise. Conversely, if market rates decline, ARM payments could decrease. Lenders often offer ARMs with an initial interest rate that is lower than fixed-rate options.
Deciphering the 3/6 ARM Numbers
The designation “3/6” in a 3/6 ARM indicates two aspects of the loan’s structure. The first number, “3,” signifies the interest rate remains fixed for an initial three years. During this period, the monthly payment will not change, providing predictable housing costs.
Following this initial three-year fixed period, the second number, “6,” indicates the interest rate will adjust every six months for the remainder of the loan term. After the initial 36 months, the borrower’s interest rate and monthly payment will be recalculated twice a year. For example, on a typical 30-year mortgage, the adjustable period lasts for the remaining 27 years, with semiannual adjustments.
Components of the Adjustable Rate
After the initial fixed period, an ARM’s interest rate is determined by combining an index and a margin, while also being subject to various caps. The index is a benchmark interest rate that fluctuates with general market conditions, and it is beyond the lender’s control. Common indexes include the Secured Overnight Financing Rate (SOFR) or the Constant Maturity Treasury (CMT) rate.
The margin is a fixed percentage added to the index rate by the mortgage lender to establish the borrower’s interest rate. This margin is set at loan origination and remains constant throughout the life of the loan. For instance, if the index is 4% and the margin is 2.5%, the interest rate would be 6.5%, before considering any caps.
Interest rate caps limit how much the interest rate can change:
- An initial adjustment cap limits the first rate change after the fixed period expires, often by 2% or 5%.
- Subsequent adjustments are governed by a periodic adjustment cap, which restricts how much the rate can change from one adjustment period to the next, typically by 1% or 2%.
- A lifetime cap sets the maximum interest rate that can be charged over the entire loan term, commonly around 5% or 6% above the initial rate.
How Your Payments Change
Interest rate adjustments directly tie to the underlying index’s movement. Once the initial fixed-rate period concludes, changes in the index rate lead to increases or decreases in the monthly payment, constrained by established caps. For example, if the index rises, the interest rate will increase (within cap limits), resulting in a higher monthly payment. Conversely, a declining index can lead to a lower interest rate and reduced monthly payments.
This variability differs from a fixed-rate mortgage, where the principal and interest portion of the payment remains constant. Borrowers with ARMs must be prepared for changing housing costs.