Adjustable-Rate Mortgage (ARM)
Definition
An adjustable-rate mortgage (ARM) has an interest rate that changes periodically based on market conditions, typically after an initial fixed-rate period. The rate adjustment is tied to a financial index plus a margin.
Example
A borrower gets a 5/1 ARM at 5% initial rate with a 2% periodic cap and 6% lifetime cap, margin of 2.5%. After 5 years, if the index is 4%, the new rate would be 4% + 2.5% = 6.5%. But the periodic cap limits the increase to 7% (5% + 2%). The rate can never exceed 11% (5% + 6% lifetime cap).
Exam Tip
Know the components: Index + Margin = Fully Indexed Rate. Understand the three types of caps: periodic (per adjustment), lifetime (total increase), and payment cap. A common exam question: "What is the maximum rate?" Answer: Initial rate + lifetime cap. The margin stays the same throughout the loan.
Related Financing Terms
Conventional Loan
A conventional loan is a mortgage that is not insured or guaranteed by a government agency such as the FHA, VA, or USDA. It is originated and funded by private lenders and may be conforming or non-conforming.
FHA Loan
An FHA loan is a mortgage insured by the Federal Housing Administration that allows lower down payments and credit scores than conventional loans. It is designed to help first-time homebuyers and borrowers with limited resources.
VA Loan
A VA loan is a mortgage guaranteed by the Department of Veterans Affairs available to eligible veterans, active-duty service members, and surviving spouses. It offers no down payment and no private mortgage insurance requirements.
Fixed-Rate Mortgage
A fixed-rate mortgage has an interest rate that remains constant for the entire term of the loan, resulting in equal monthly principal and interest payments throughout the life of the mortgage.
Loan-to-Value Ratio (LTV)
The loan-to-value ratio (LTV) is the percentage of a property's appraised value or purchase price (whichever is lower) that is being financed through a mortgage. LTV = Loan Amount / Property Value.
Debt-to-Income Ratio (DTI)
The debt-to-income ratio (DTI) compares a borrower's monthly debt obligations to their gross monthly income. It is used by lenders to determine how much mortgage a borrower can afford.
Frequently Asked Questions
Test Your Financing Knowledge
Practice with exam-style questions to make sure you can apply Adjustable-Rate Mortgage (ARM) and other financing concepts.