Adjustable-Rate Mortgage (ARM)
What it is:
How it works (Example):
In many cases, ARMs have caps -- limits on how high and sometimes how low the interest rate can go, and how much they can move in any one year, month, or quarter. In some cases, the interest rate will only adjust up -- that is, borrowers will get no benefit if interest rates fall.
To understand how adjustable interest rates affect a borrower's payment, let's assume that a bank offers a $100,000 ARM to a potential borrower. The interest rate is the prime rate plus 5% with a maximum of 10%. If the prime rate is 3%, then the borrower's interest rate is 8% (5% + 3%), and the monthly payment would be $733.77. But if the prime rate increases to, say, 4%, then the loan's interest rate resets to 9% (5% + 4%), and the payment is now $804.63.