What is an Adjustable Rate Mortgage (ARM)
An adjustable rate mortgage, also known as an ARM, is a mortgage where the interest rate is periodically adjusted based on an index such as the Prime Interest Rate. These mortgages typically carry a lower initial mortgage payment. However, the potential exists for monthly payments to rise should interest rates increase, making ARMs a wise choice for those whose income may go up over the life of the loan, or those who plan on moving within the next few years.
Also known as variable rate mortgages, theThe idea behind ARMs is to ensure a steady margin for the lender, whose own cost of funding will usually be related to the same index. Adjustable rate mortgages, also known as variable rate mortgages, differ from graduated payment mortgages, which offer changing payment amounts but a fixed interest rate. The main characteristics of adjustable mortgage rates are the index and limitations on charges, also known as caps.
The main characteristics of adjustable mortgage rates are the index and limitations on charges, also known as caps.
The four components of ARMs are:
- Index
- Margin
- Interest rate cap structure
- Initial interest rate period
The two types of caps—annual and life-of-the-loan—protect the borrower from large interest rate swings. While the annual cap restricts the amount that the interest rate can change in any given year, the life-of-the-loan cap limits the maximum (and minimum) interest rate the borrower can pay for as long as he has the mortgage.