Question:

Definition of Adjustable Rate Mortgage (ARM)

Answer:

Adjustable Rate Mortgage (ARM) is a mortgage that begins with a lower rate than a Fixed Rate Mortgage and interest will stay low for a number of years (say 3, 5 years). After the preset period expires, the rate will fluctuate according to the Treasury Bill rate, or the prime rate, or other indices such as COFI and LIBOR in order to adjust to market rates. Rates may go up or down and may be adjusted once or twice a year. ARM are usually labeled 3/1, 5/1, 7/1, which means that the loan will have fixed rates for respectively 3, 5, 7 years, and then the rate will be adjusted annually.

Borrowers of the Adjustable Rate Mortgage are protected by a number of the so-called caps to avoid payment shock once the rate is loosened. The initial adjustment cap will be around 2-3 percent for, say, 3/1 ARM, and 5-6 percent for a 5/1 ARM. The longer the fixed period, the greater rate adjustment is demanded by the lender.

The rate adjustment cap limits successive adjustments to usually 1 to 2 percent.

ARMs also have a lifetime cap - this is the maximum interest rate the ARM can reach for the life of the loan - usually 5-6 percent above the start rate.

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Common misspellings: mortage and morgage