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Finance Glossary

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The key letter in ARM is "a" and it stands for adjustable as in adjustable rate mortgage.  Adjustable means that the mortgage payment is a moving target. The interest rate can be adjustable. The payment terms can be adjustable and the time to bankruptcy can also be adjustable. In times when interest rates are expected to increase, adjustable rates are typically lower than the prevailing fixed interest rates and the opposite is true as well. 

A typical ARM has a low interest rate, a guaranteed period of time for that interest rate, an index (like LIBOR) against which it is adjusted, a step up percentage (how much the interest rate will likely grow each period) and hopefully a cap (the maximum rate it can be raised in a given period). 

Sometimes an ARM can be in the form of interest only for the first few years. There are very low payments but no principle is paid down. The buyer is making a bet that interest rates in that timeframe will be less than they are today and that the buyer’s income will go up.  

An ARM at a 3.75% guaranteed interest rate for the first 5 years, a .25% step up and a 12% cap has a schedule that looks like this: 

Year Interest Rate Monthly Payment Annual Payment
1-5 3.75% $1,111 $13,338
6 4.00% $1,141 $13,693
15 6.50% $1,399 $16,526
30 10.00% $1,572 $18,864 

The reason people buy an ARM in the first place is because they are cheap or appear cheap to the borrower. Sometimes they are actually cheap to the borrower.

Often they are not. Bank consortiums, which price mortgages, are usually smarter about the pricing of mortgages than Joe the Plumber. Yet there is always a guy who wins the lottery. What happens if the interest rate steps up at intervals of 1% instead of .25%?

Year Interest Rate Monthly Payment Annual Payment
1-5 3.75% $1,111 $13,338
6 4.75% $1,232 $14,790
15 12.00% $2,146 $25,753
30 12.00% $2,146 $25,756 

Let’s compare this to a fixed rate 5.25% mortgage. 

Year Interest Rate Monthly Payment Annual Payment
1 5.25% $1,325 $15,903
6 5.25% $1,325 $15,903
15 5.25% $1,325 $15,903
30 5.25% $1,325 $15,903 

Notice, you are making a trade-off between low interest in the early years (ARM) and certainty (Fixed) in the later years.