ARM - Adjustable Rate Mortgage An Adjustable Rate Mortgage, frequently referred to simply as ARM is a type of mortgage with interest rate tied to an index. The fact that the adjustable rate mortgages interest rate is dependent on certain index, means that the interest rate that the borrower pays on his mortgages changes along with the index. Don't get confused if you encounter the terms “variable rate mortgage” or “floating rate mortgage”, as they both refer to ARM, or mortgage with floating interest rate. The adjustable rate mortgages shift part of the risk from the lender to the borrower. If the index to which the ARM is tied goes up, so does the interest on the mortgage (the borrower loses) and if the index goes down, the interest payments go down too. An adjustable rate mortgage is generally divided in 2 periods. The first period is with fixed interest rate, and can last from 1 month to several years - the longer the initial period is, the higher the initial interest rate. Mortgage lenders frequently offer low introductionary interest rates, often call “teaser rates”, but anybody considering ARM, should be aware that their interest rates may go up sharply, after that period. The second period of the ARM is the period where the mortgage interest rate is adjusted depending on the index it is tied to. Some adjustable rate mortgages have the option to convert to fixed rate mortgages, something that borrowers frequently do in rising interest rate environment. Most Canadian banks offer adjustable rate mortgages, but still Canadian consumers are not well informed about the advantages and disadvantages of the adjustable rate mortgages. Adjustable Rate Mortgage Indexes There are many different indexes used to calculate the interest rate on adjustable rate mortgage loans. For example some of the indexes used in US are 12-month Treasury Average Index, Constant Maturity Treasury, LIBOR (London Interbank Offered Rate), and the National Average Contract Mortgage Rate. One of the European indexes used in ARM is the Euro Interbank Offered Rate (EURIBOR). In Canada adjustable rate mortgage interest rate might be linked to the prime interest rate. Adjustable Rate Mortgage Example Here is an example of adjustable rate mortgage. John borrows to buy a house and decides to go with ARM with interest rate defined as Prime Rate minus 0.5%. If the prime rate is 6.5% then John pays 6% interest rate on his mortgage loan. If the prime rate goes up to 8%, then Johns mortgage interest rate goes up as well to 7.5%. Adjustable Rate Mortgage Interest Caps The rate caps specified in the ARM loan contract, limit the interest that the borrower can be charged. There are 2 general ARM interest caps. The first one caps the amount of interest rate increase, between 2 consecutive adjustment periods. For example if you have an adjustable rate mortgage, and your interest rate adjusts once every 6 months, then you might have a cap of 1% interest rate increase per adjustments, which will work out to 2% maximum adjustment per year. The second type of adjustable rate mortgage cap defines the maximum interest rate increase allowed for the entire life of your mortgage loan. Typical total interest rate adjustment cap will be in the 5%-6% range. In conclusion adjustable rate mortgages are riskier compared to fixed rate mortgages, because of uncertainty in the direction of the future interest rates. However ARM allow borrowers to finance their homes cheaper, when interest rates are low.