ARM (Adjustable Rate Mortgage)
An adjustable rate mortgage (ARM) is a home loan with an interest rate that changes periodically based on market conditions, typically starting with a lower fixed rate before adjusting.
š¬ Video Explanation
Exam Tip
5/1 ARM = 5 years fixed, then adjusts yearly. Know the caps: initial, periodic, lifetime.
What is an Adjustable Rate Mortgage (ARM)?
An ARM is a mortgage loan where the interest rate adjusts periodically based on a benchmark index. ARMs typically offer lower initial rates than fixed-rate mortgages but carry the risk of rate increases.
ARM Structure
| Component | Description |
|---|---|
| Initial Rate | Fixed rate for introductory period (often lower than fixed-rate mortgages) |
| Adjustment Period | How often rate changes (annually, every 6 months) |
| Index | Benchmark rate ARM is tied to (SOFR, Treasury, etc.) |
| Margin | Fixed percentage added to index to determine your rate |
Common ARM Types
| Type | Initial Fixed Period | Then Adjusts |
|---|---|---|
| 5/1 ARM | 5 years | Every year after |
| 7/1 ARM | 7 years | Every year after |
| 10/1 ARM | 10 years | Every year after |
| 5/6 ARM | 5 years | Every 6 months after |
Rate Caps
ARMs have caps to limit rate increases:
| Cap Type | Limits |
|---|---|
| Initial Cap | Max first adjustment (often 2%) |
| Periodic Cap | Max each subsequent adjustment (often 2%) |
| Lifetime Cap | Max over loan life (often 5-6% above initial) |
ARM vs. Fixed Rate
| Factor | ARM | Fixed Rate |
|---|---|---|
| Initial Rate | Lower | Higher |
| Payment Predictability | Less | More |
| Best If | Plan to sell/refinance early | Staying long-term |
| Risk | Rate increases | Rates drop, you're locked in |
When ARMs Make Sense
- Planning to sell before adjustment period
- Expecting rates to fall
- Need lower initial payments
- Confident income will increase
Study This Term In
Related Terms
Mortgage
A mortgage is a loan used to purchase real estate, where the property serves as collateral, typically repaid over 15-30 years with interest.
Interest Rate Risk
Interest rate risk is the potential for investment losses due to changes in interest rates, particularly affecting fixed-income securities like bonds whose prices fall when rates rise.
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