An adjustable rate mortgage, which is often abbreviated to ARM, is a mortgage loan in which the loan payments can adjust throughout the life of the mortgage loan. Unlike a traditional fixed rate loan where the interest rate is set at the beginning of the loan and never changes, an ARM's interest rate is recalculated and reset at intervals, typically every six or twelve months. As the interest rate associated with the ARM goes up or down, so do the monthly loan payments.
Most adjustable rate mortgage loans offer a lower "teaser" rate for the first few months of the loan; the lower introductory rate generally lasts anywhere from three to eighteen months before the loan resets to a prevailing rate of interest. Since this introductory interest rate is lower than the interest rate on a thirty-year fixed rate mortgage, borrowers can save quite a bit of money on their monthly loan payments during this initial period. The lower interest rate associated with an adjustable rate mortgage also means that borrowers can qualify for and afford a more expensive home.
The interest rate on adjustable rate mortgage will reset after the introductory period lapses and then at set time intervals thereafter. The exact procedure regarding how the interest rate can adjust is specified in the loan documents; typically, the ARM's interest rate is equal to a market index rate, such as the one-year Treasury securities rate (CMT) or the London Interbank Offered Rate (LIBOR), plus a margin of a few percentage points. Most ARMs have caps, which are limits, on how much the loan's interest rate can move upon recalculation, which is good protection in case the market index rate suddenly spikes.
Since an adjustable rate mortgage offers low monthly payments at the beginning of the loan, it is usually a great choice for borrowers who intend to live in their home for just a short period of time. On the other hand, since the interest rate associated with an ARM can increase steadily after the expiration of the initial "teaser" rate period, an adjustable rate mortgage may not be a wise choice for borrowers who intend to live in their home for a number of years and for borrowers who are averse to risk. These types of borrowers may be more comfortable with a fixed-rate mortgage loan.