An adjustable rate mortgage is a long-term loan you use to finance a real estate purchase, typically a home. Unlike a fixed-rate mortgage, where interest rate remains the same for the term of the loan, the interest rate on an ARM is adjusted, or changed, during its term.
The initial rate on an ARM is usually lower than the rate on a fixed rate mortgage for the same term, which means it may be easier to qualify for an ARM. You take the risk, however, that interest rates may rise, increasing the cost of your mortgage. Of course, its also possible that the rates may drop, decreasing your payments.
The rate adjustments, which are based on changes in one of the publicly reported indexes that reflect market interest rates, occur at preset times, typically once a year but sometimes every three, five, or seven years. Typically, rate changes on ARMs are capped both annually and over the term of the loan, which helps protect you in the case of a rapid or sustained increase in market rates.
However, certain ARMs allow negative amortization, which means additional interest could accumulate on the outstanding balance if market rates rose higher than the cap. That interest would be due when the loan matured or if you want to prepay.