What Is a 3/27 Adjustable-Rate Mortgage (ARM)?

A 3/27 adjustable-rate mortgage (ARM) is a 30-year mortgage frequently offered to subprime borrowers. Subprime borrowers are borrowers with lower credit scores or a history of loan delinquencies; they are considered to represent a higher risk to lenders.

This type of mortgage loan is designed as a short-term financing vehicle that gives borrowers time to repair their credit until they are able to refinance into a mortgage with more favorable terms.

Key Takeaways

  • A 3/27 adjustable-rate mortgage (ARM) is a 30-year mortgage frequently offered to subprime borrowers.
  • 3/27 ARMs are designed as a short-term financing vehicle that gives borrowers time to repair their credit until they are able to refinance into a mortgage with more favorable terms.
  • 3/27 ARMs have a three-year fixed interest rate period—interest is generally lower than the current rates on a 30-year conventional mortgage.
  • After three years, and for the remaining 27 years of the loan, the rate floats based on an index, such as the London Interbank Offered Rate (Libor) or the yield on one-year U.S. Treasury bills.
  • Many 3/27 ARM borrowers fail to recognize how much their monthly payments increase after three years; because payments can rise so significantly, borrowers should plan carefully before taking out a 3/27 ARM.

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

In general, adjustable-rate mortgages (ARMs) are a type of mortgage in which the interest rate applied on 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 interest rate resets periodically, at yearly or even monthly intervals.

ARMs can be contrasted to fixed-rate mortgages. (Fixed-rate mortgages and adjustable-rate mortgages (ARMs) are the two primary mortgage types.) A fixed-rate mortgage charges a set rate of interest that does not change throughout the life of the loan.

3/27 ARMs have a three-year fixed interest rate period—interest is generally lower than the current rates on a 30-year conventional mortgage. But after three years, and for the remaining 27 years of the loan, the rate floats based on an index, such as the London Interbank Offered Rate (Libor) or the yield on one-year U.S. Treasury bills.

The bank also adds a margin on top of the index; a margin is the number of percentage points added to the index by the mortgage lender to set your interest rate on an adjustable-rate mortgage (ARM). The total is known as the spread or the fully indexed interest rate. This rate typically is substantially higher than the initial three-year fixed interest rate, although 3/27 ARMs usually have caps on the increase.

Commonly, these loans top out at a rate increase of 2% per adjustment period, which could occur every six or 12 months. Keep in mind: That means the rate can increase by two full points (not 2% of the current interest rate). There might also be a life-of-the-loan cap of 5% or more.

To avoid payment shock when the interest rate begins to adjust, purchasers of 3/27 ARM mortgages typically intend to refinance the mortgage within the first three years.

Disadvantages of a 3/27 Adjustable-Rate Mortgage (ARM)

A serious risk for borrowers is that they cannot afford to refinance their loan in three years. This could be due to a credit rating that is still sub-standard, or a drop in the value of their home, or simply market forces that cause interest rates to rise across the board. Moreover, many 3/27 mortgages carry prepayment penalties, which make refinancing costly.

Many 3/27 mortgage borrowers fail to recognize how much their monthly payments increase after three years.

For example, say a borrower takes out a $250,000 loan at an initial rate of 3.5%. While this is a great mortgage rate at the start, let’s assume that after three years, the floating interest rate is at 3% and the bank’s margin is 2.5%.

That adds up to a fully indexed rate of 5.5%, which is within the loan’s 2-point annual cap. Overnight, the monthly payment goes from $1,123 to $1,483, a difference of $360. Because payments can rise so significantly, borrowers should plan carefully before taking out a 3/27 mortgage.