What Is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage (ARM) is a mortgage in which the interest rate may change over time, usually in relation to an index (such as the London Interbank Offered Rate, or LIBOR), and payments may “adjust” up or down accordingly.

Unlike a fixed-rate mortgage, homeowners with this type of home loan aren’t guaranteed the same interest rate for the duration of their loan. The risk of an increasing interest rate is something that borrowers should take into account when considering an adjustable-rate mortgage for their home financing.

Adjustable-Rate Mortgage Benefits

Because the borrower assumes more risk with this type of mortgage, adjustable-rate mortgages offer prospective homeowners some notable benefits.
 
Compared to a fixed-rate mortgage, adjustable-rate mortgages typically offer lower initial interest rates and monthly payments than fixed rate mortgages in exchange for possible future rate adjustments. The initial interest rate is fixed for a set period, such as 3 to 10 years, and the interest rate adjusts up or down depending on market conditions after that.

Adjustable-rate mortgages can be a great option for homebuyers who plan to relocate or expect their income to increase.

Adjustable-rate mortgage benefits include:

• Lower initial interest rate than fixed-rate mortgages, which means you will enjoy a lower monthly payment during the initial term.
• Flexibility for buyers who plan to move in the future or who anticipate their income increasing.

Interest Rate Caps

Depending on the type of mortgage selected, interest rate caps offer some protection for homeowners who opt to finance their home with an adjustable-rate mortgage. An interest rate cap sets a limit on the amount the interest rate can increase.

There are two types of interest rate caps: periodic and lifetime. A periodic adjustment cap limits the amount an interest rate can increase or decrease between two adjustment periods after the first adjustment. A lifetime cap limits the amount the interest rate can increase over the duration of the loan.

Payment Caps

Payment caps follow a similar structure as interest rate caps. Payment caps limit the amount the monthly payment may increase from one adjustment period to another, instead of the amount the interest rate can increase.

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