An Adjustable-Rate Mortgage (ARM) is a type of mortgage loan in which the interest rate can change periodically over the life of the loan. The interest rate on an ARM is typically tied to a specific financial index, such as the U.S. Treasury Bill rate or the London Interbank Offered Rate (LIBOR). As the index rate fluctuates, the interest rate on the ARM adjusts accordingly, leading to changes in the borrower’s monthly mortgage payments.

Key features of Adjustable-Rate Mortgages include:

1. **Initial Fixed Period:**
– Many ARMs have an initial fixed-rate period, during which the interest rate remains constant. This period can range from a few months to several years. For example, a 5/1 ARM has a fixed rate for the first five years and then adjusts annually.

2. **Adjustment Period:**
– After the initial fixed period, the interest rate on the ARM adjusts at regular intervals. Common adjustment periods are annually, every three years, or every five years, depending on the terms of the loan.

3. **Index and Margin:**
– The interest rate adjustments are tied to a specified financial index. The lender adds a margin (a fixed percentage) to the index rate to determine the new interest rate. For example, if the index rate is 3% and the margin is 2%, the adjusted interest rate would be 5%.

4. **Caps:**
– To limit the potential impact of interest rate fluctuations, ARMs often have caps, which set limits on how much the interest rate can increase or decrease during a specific time period. Common caps include periodic caps (limiting adjustments within a specific period) and lifetime caps (limiting adjustments over the entire loan term).

5. **Payment Shock:**
– One potential risk with ARMs is the possibility of payment shock. If interest rates rise significantly, borrowers may experience a sharp increase in their monthly mortgage payments after an adjustment.

6. **Interest Rate Index:**
– The choice of the interest rate index affects how the ARM interest rate adjusts. Common indices include the Constant Maturity Treasury (CMT) index and the London Interbank Offered Rate (LIBOR).

7. **Risk and Reward:**
– ARMs offer the potential for lower initial interest rates compared to fixed-rate mortgages. However, they also carry the risk of future rate increases, leading to higher payments.

8. **Refinancing:**
– Borrowers may choose to refinance an ARM into a fixed-rate mortgage if they are concerned about potential interest rate increases or if they prefer the stability of fixed monthly payments.

Adjustable-Rate Mortgages can be suitable for certain borrowers, especially those who plan to stay in their homes for a relatively short period or expect interest rates to remain stable or decline. However, borrowers should carefully consider the potential risks and future payment scenarios when choosing an ARM, particularly if they plan to stay in their homes for an extended period. Lenders are required to provide clear disclosure of the terms and potential payment adjustments associated with ARMs.