What is an Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that changes over time. Typically, an ARM starts with a lower, fixed interest rate for an initial period (e.g., 5 or 7 years). After this introductory period ends, the interest rate adjusts periodically, often once a year, based on a benchmark financial index. This means your monthly payment can go up or down.

How Do ARMs Work?

An ARM's interest rate is made up of two parts: an **index** and a **margin**. The index is a benchmark interest rate that reflects general market conditions, while the margin is a fixed percentage added by the lender. When it's time to adjust, the lender adds the current index value to the margin to determine your new rate. To protect borrowers from extreme changes, ARMs have caps:

• Periodic Caps: Limit how much the rate can change in one adjustment period.
• Lifetime Caps: Set a maximum interest rate the loan can ever have.

Frequently Asked Questions (FAQ)

What is the difference between an ARM and a fixed-rate mortgage?

With a fixed-rate mortgage, the interest rate is locked in for the entire life of the loan, so your principal and interest payment never changes. With an ARM, the rate is fixed for only an initial period and can then change periodically, causing your monthly payment to increase or decrease.

What is an advantage of an adjustable-rate mortgage?

The primary advantage of an ARM is the lower initial interest rate compared to a fixed-rate mortgage. This results in a lower monthly payment during the fixed period, which can make a home more affordable upfront or free up cash for other expenses.

What do the numbers in an ARM mean (e.g., 5/1 ARM)?

The numbers describe the loan's structure. In a "5/1 ARM," the first number (5) indicates the initial fixed-rate period in years. The second number (1) indicates how often the rate adjusts in years after the fixed period ends. So, a 5/1 ARM has a fixed rate for the first 5 years and then adjusts every 1 year thereafter.