An adjustable-rate mortgage (or ARM, for short) is a mortgage with an interest rate that periodically changes throughout the duration of the loan. Unlike fixed-rate mortgages, the interest rates for ARMs are tied to an outside index, meaning that the rates (and monthly payments) may rise or fall along with the index.
The basic features of an ARM are:[1]
- Introductory rate
- Lenders commonly offer a low introductory rate for a specified period of time at the beginning of the mortgage. After this period ends, the rate resets to reflect the annual percentage rate (APR) as determined by the mortgage agreement.
- Adjustment period
- The adjustment period is the time between rate changes. For example, a 1-year ARM will have its interest rate and monthly payment changed once every twelve months.
- The index
- The index is a measure of general prevailing interest rates. The interest rates for ARMs are determined by taking an index rate and adding an extra amount (known as the margin). Changes in the index to which an ARM's interest rate is tied are what lead to increases or decreases in the monthly payment. Common indexes include: 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).
There are three main types of ARMs: hybrid ARMs, interest-only ARMs, and option ARMs.
