What is an adjustable-rate mortgage?
An adjustable-rate mortgage, or ARM, is a mortgage with an interest rate that can be increased or decreased from time to time, depending on various factors. An ARM is helpful for someone taking out a mortgage during a period of low interest rates, especially if the ARM has a relatively longer fixed-rate period.
Traditional fixed-rate mortgages have an interest rate agreed upon at the time of closing that remains in place throughout the entire term of the loan. An adjustable-rate mortgage allows for the lender to change the interest rate at certain points during the term of the loan. Adjustable-rate mortgages often start out with a low interest rate, even sometimes below market rates. However, the rate can increase or decrease significantly over the life of the loan.
Most ARMs, like the 7/1 ARM, have an initial period during which the interest rate remains fixed, followed by a period during which the lender may periodically adjust the interest rate. Adjustments typically happen every six months or annually, although sometimes rates are adjusted monthly.
In the adjustable rate period of an ARM, the interest rate charged is dictated by a standard financial index, such as the key index rate set by the Federal Reserve or the London Interbank Offered Rate (Libor). As the interest rates dictated by the underlying financial index change, it becomes more likely that the lender will also revise the ARM’s interest rate.
Looking for an ARM that won’t cost an arm and a leg? Check out Bankrate’s mortgage-rate comparison tool.
Adjustable-rate mortgage example
Several types of adjustable-rate mortgages are available. A 5/1 ARM has an introductory rate of five years. After that first five-year period expires, the interest can change annually. A 5/5 ARM features a fixed period for five years, with a change allowed every five years after that initial period. Another type is a 2/28 ARM. In this form, a fixed rate remains in place for two years. Then, a floating rate (a rate that can adjust from time to time) occurs over the next 28 years.