An adjustable rate mortgage, also known as ARM or floating rate mortgage, is a type of mortgage with a flexible interest rate. This means the percentage rate fluctuates based on an index, and it is adjusted to always benefit the lender, not matter how the market changes. There are basically five types of indexes used to calculate the interest rate on adjustable rate mortgage. These are: the Constant Maturity Treasury (CMT), the 11th District Cost of Funds Index (COFI), the 12-month Treasury Average Index (MTA), the National Average Contract Mortgage Rate, and the London Interbank Offered Rate (LIBOR).
An adjustable rate mortgage is a common solution for financial institutions that cannot afford the risk of fixed loans, such as banks funded by customer deposits only, or for loan companies offering a loan to people without a credit history, or those requesting a rather large loan. An adjustable rate mortgage is not necessarily a bad arrangement for the borrower, just a more risky one. In the case of the index falling, the borrower may end up paying less than he would on a regular mortgage loan. In fact, an adjustable rate mortgage is the most common type of mortgage offered by banks in Canada, the United Kingdom, and Australia. Short-term loans can be fixed in these countries, but any loan or mortgage over ten years will normally take the form of an adjustable rate mortgage.
An adjustable rate mortgage often comes with a cap or limitation on charges, which controls either the frequency or the lifetime change of the interest rate. For example, an adjustable rate mortgage can have a cap of a two percent maximum per year, or six percent total during the lifetime of the mortgage. This protects the borrower while still ensuring the lender a fairly safe transaction. Another type of borrower protection is the adoption of a hybrid adjustable-rate mortgage, in which the interest rate only becomes floating after a certain period of time, like a year or so. This gives the borrower the chance to adjust his or her lifestyle enough to deal with the rate change without any major consequences.
