How does an adjustable-rate mortgage (ARM) function?

An adjustable-rate mortgage (ARM) functions by allowing for periodic interest rate changes based on market conditions. This means that the interest rate on the loan can fluctuate at designated intervals, such as annually or biannually, depending on a specified index that reflects current market rates. Initially, ARMs often start with a lower fixed interest rate for a certain period, which can make them attractive to borrowers looking for lower initial payments. After this initial fixed period ends, the rate adjusts according to the predefined terms, which can lead to changes in the monthly mortgage payment.

The workings of an ARM are designed to align the loan's interest rate with the prevailing market conditions, providing flexibility that can benefit borrowers if interest rates remain stable or decline. However, this can also present risks if interest rates rise significantly during the adjustment periods, potentially increasing the borrower's payment obligations substantially over time.

This understanding of how ARMs operate highlights why this option accurately captures their unique characteristics and functionality.