An adjustable rate mortgage (ARM) refers to a type of home loan whereby the interest rate fluctuates based on external factors, typically tied to a specified financial index. While traditional fixed-rate mortgages have a predetermined interest rate over the loan term, an adjustable rate mortgage offers a variable interest rate that adjusts periodically, usually at set intervals.
The adjustment in interest rates for an ARM is contingent on the index it is connected to, such as the U.S. Treasury bill rate or the London Interbank Offered Rate (LIBOR). When the index rate changes, the interest rate on the adjustable rate mortgage is recalculated accordingly. These adjustments often occur annually, although they can take place as frequently as monthly or as infrequently as every three to five years, depending on the terms agreed upon in the loan agreement.
Adjustable rate mortgages often have an initial fixed-rate period, usually ranging from one to ten years, during which the interest rate remains constant. Following this period, the interest rate adjusts periodically, typically rising or falling in response to changes in the index. This unavoidably creates a level of uncertainty for the borrower as they cannot predict the future interest rates beyond the fixed-rate period, making it imperative to comprehend the potential financial obligations associated with an adjustable rate mortgage.
Borrowers who opt for adjustable rate mortgages are generally attracted to the potentially lower initial interest rates offered during the fixed-rate period, which could allow them to afford a more expensive property or free up funds for other investments. However, the inherent risk lies in the fact that once the adjustable period commences, fluctuations in the interest rate can lead to significant changes in mortgage payments, potentially resulting in increased financial burden for the borrower.
