An Adjustable Rate Mortgage, often known as an ARM, is a home loan that begins with a fixed interest rate for a period of time and then later changes to a variable interest rate. The most common ARM loans are 30-year loans with fixed interest rates for 5, 7 and 10 years. For example, a 5/1 ARM means that the interest rate is fixed for 5 years and then adjusts every one year afterwards.
Interest rates on an Adjustable Rate Mortgage are usually calculated based on an index like the LIBOR (London Interbank Offered Rate) or COFI (Cost of Funds Index). When a bank adjusts the interest rate on an ARM, it adds a margin to the value of the index on a particular day. Interest rates can go up or down, depending on the value of the index.
ARMs usually offer lower interest rates than a 30-year fixed rate loan. This is because banks are not taking such a long-term interest rate risk. While adjustable rate mortgages can be more affordable to begin with, they do come with risk that your payments will go up, sometimes substantially, in the future.