Definition
Also known as a variable rate mortgage, an adjustable rate mortgage (ARM) is a home loan whereby the interest rate charged can change over the term of the loan. Typically, the rate adjusts, or tracks, with a well-defined index such as the Cost of Funds Index (COFI) or the London Interbank Offer Rate (LIBOR).
Explanation
Since the interest rate can change with an adjustable rate mortgage, the monthly payments due on the loan can rise or fall over the term of the loan. This behavior is in contrast to a fixed rate mortgage, whereby the interest rate is constant over the term of the loan. Oftentimes, an interest rate cap is placed on the loan, whereby the rate charged can be no higher than a pre-determined value. These can be periodic caps (per adjustment period) or lifetime caps (life of the loan).
Fair comparisons of all loan types can be made using the annual percentage rate, or APR. The lender's risk of rising or falling interest rates is passed on to the borrower with an ARM. By doing so, the lender is able to offer more attractive initial interest rates to consumers when compared to conventional loans.
Example
Bank A is advertising a 30 year 5-year ARM, with an initial interest rate of 3.000% and an APR of 3.015%. The loan has a lifetime cap of 8.000% and a periodic cap of 1.000%. This information is translated as follows:
The length of the loan is 30 years. The initial rate of 3.000% cannot change in the first five years. After that, the rate will track a well-known index and cannot increase more than 1.000% at the point of each adjustment period.
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