ADJUSTABLE RATE MORTGAGE (ARM)

Also known as a Variable Rate Mortgage (VRM). A mortgage where the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly. The note rate equals the rate at the beginning of the loan. The contract rate is determined by adding the interest rate and the margin at specified adjustment periods.

Lenders generally charge lower initial interest rates, (note rate) for ARMs than for fixed-rate mortgages. This makes the ARM easier on the borrower's pocketbook at first than a fixed-rate mortgage of the same amount. It also means that the borrower might qualify for a larger loan because lenders sometimes make this decision on the basis of the borrower's current income and the first year's payments. Moreover, an ARM could be less expensive over a long period than a fixed-rate mortgage. For example, if interest rates remain steady or decrease.

Against these advantages, the borrower must weigh the risk that an increase in interest rates would lend to higher monthly payments in the future. There is a trade off - the borrower gets a lower rate with an ARM mortgage in exchange for assuming more risk.

For more information, read the Consumer Handbook on Adjustable Rate Mortgages (CHARM) booklet put out by the Federal Reserve Board and the Federal Home Loan Bank Board.