An adjustable-rate mortgage (ARM) is a mortgage loan in which your interest rate changes at set intervals during the life of your loan. The most common ARM loans are for 5, 7, or 10 years. For example, a 30-year loan with a 5/1 ARM means that you’ll pay a fixed interest rate for five years, then your rate will change each year after that for the rest of the loan.
ARM rates change based on an index, such as the LIBOR. This index measures the cost for banks and lending institutions to borrow money from each other, which then affects the interest rate they charge borrowers. Most lenders will charge borrowers a rate based on an index, and then add a margin above this rate. This margin is usually expressed as the index LIBOR + 1%, or 2%, depending on the terms of the loan. ARMs can make financial sense if the borrower is planning to sell or refinance before the introductory period ends and the rate resets, or if she believes rates will be lower in the future. However, buyers should be aware that a rise in interest rates during the initial period may make it more difficult to refinance or sell when the time comes.