An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can change over time, based on a specified index. With an ARM, the interest rate is typically lower than that of a fixed-rate mortgage in the initial years of the loan, making it a popular choice for borrowers who plan to sell the property or refinance the loan before the interest rate adjusts.
The interest rate on an ARM is tied to an index, such as the London Interbank Offered Rate (LIBOR) or the Treasury Bill Rate, which serves as a benchmark for the lender to determine the interest rate. The lender also sets a margin, which is a fixed percentage added to the index rate to determine the interest rate on the loan.
The interest rate and the payment amount can change at set intervals, such as every year or every 5 years. The change in the interest rate can affect the payment amount, which may result in it increasing or decreasing. It's important for borrowers to understand that with an ARM, the interest rate and the payment amount are not fixed, and can change over time. This means that the borrower could potentially end up paying more in interest over the life of the loan.
Before getting an ARM, it's important to understand the terms of the loan, specifically the index rate, the margin, and the frequency of adjustments. Borrowers should also have a plan in place for what to do if interest rates rise and the payment becomes unaffordable. This can include refinancing to a fixed-rate mortgage, selling the property, or seeking a loan modification.
ARM's can be beneficial for some borrowers because they can have lower interest rates in the beginning, but it's important to understand the risks of the loan and the potential for the interest rate and payment to increase in the future. It's important to make sure that the adjustable rate mortgage loan fits the borrower's financial goals and capacity to repay the loan.