Adjustable rate mortgage (ARM)
An adjustable rate mortgage is a type of real estate loan in which the interest rate is adjusted or changes periodically to reflect changes in the market. It is a type of adjustable mortgage loan. It may also be called a variable rate mortgage or floating rate mortgage.
Adjustable mortgage loans usually have much lower initial installments compared to fixed-rate mortgages. This means that more borrowers can afford to pay the initial installments. The initial interest rates are also usually lower, which means an overall less expensive loan, if the interest rates do not increase significantly.
The reason for this lower initial rate is that there is a high risk of having interest rates go up eventually. Hence, the low installment amount and initial interest rate is supposed to offset the subsequent increase in interest rates.
The problem with adjustable rate mortgages is the high risk associated with them.
Due to the increase in interest rates the borrower is often left with a much higher interest rate than the original rate, which means the loan amount also goes up substantially. The installment amount then also goes up significantly, since there is a larger amount to pay within the specified loan term.
This monthly payment may be more than the borrower can afford, which can lead to default. Hence, while adjustable rate mortgages may seem less expensive in the beginning, in the end it is usually more expensive.