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Adjustable Rate Mortgage

Phonetics: ad·just·a·ble rate mort·gage    \ə-'jəs-tə-bəl\ \'rāt\ \'mȯr-gij\

Function: noun

An Adjustable Rate Mortgage (ARM) is a mortgage in which the interest rate is adjusted periodically based on a preselected index. Also sometimes known as the renegotiable rate mortgage, or the variable rate mortgage. There are 30-year fully amortized options, as well as 15-year and interest only options.

Since the borrower may be offered a very attractive initial interest rate, the borrower may be inclined to believe that they could be able to borrow much more than what would be prudent to borrow. As interest rates rise, a borrower could very quickly become over his head in payments since the payment amount could rise significantly in such an instance. During 2007 and 2008, many borrowers with Adjustable Rate Mortgages lost their homes because their monthly payments were in some cases, doubled due to rising interest rates.

Adjustable Rate Mortgages typicially also integrate loan caps into the Mortgage. An Adjustable Rate Mortgage often starts with a fixed rate for the first three to five years as an incentive for the borrower to accept the loan. After the initial fixed period, an initial adjustment loan cap limits the percentage that the interest rate can be raised in a loan during the first adjustment which would occur after the fixed rate period of the loan is over. A rate adjustment cap limits the amount that the interest rate can be raised each time the loan rate is adjusted. There are also often lifetime caps of 5-6% above the initial interest rate.

A prudent investor would only accept an ARM loan if they could afford to make payments in the worst case scenario which is if the interest rate went up to the highest cap level.