Adjustable Rate Mortgage (ARM)

A mortgage in which the interest rate is periodically adjusted according to various market rates.

Lenders tend to favor ARMs because ARM rates rise and fall with market rates (the same market rates that determine what the lender is usually paying to fund the loan). In other words, ARMs are less risky for lenders. Because of this, lenders are usually more willing to offer lower introductory interest rates on ARMs.

As a borrower, you take a risk by choosing to go with an ARM. If interest rates drop, you’ve made a good financial decision. If they rise, so do your payments, meaning you would have been better off with a fixed rate mortgage (i.e., a mortgage whose interest rate doesn’t change).

Related Terms

  • Initial Rate – The introductory interest rate of the loan, also known as the teaser rate. Many times the introductory rate will be exceptionally low to entice you to choose this loan over others. It will then increase with time.
  • Index Rate – The rate that the ARM is tied to. As the index rate rises or falls, so does the interest rate of the ARM. It is important to note that the index rate is not under the control of neither the lender nor the borrower.
  • Adjustment Period – The length of time that the ARM will stay at a given rate. At the end of the adjustment period, the ARM rate will be recalculated, according to the index rate.
  • Rate Cap – A cap, or a limit, on how much an ARM rate cna change during an adjustment period, or during the length of the loan. This protects you and your lender from extreme changes in the index rate.

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