How does an adjustable-rate mortgage (ARM) work?

An adjustable-rate mortgage (ARM) operates by having an interest rate that fluctuates based on a specified index. This means that the interest rate can change at predetermined intervals—usually after an initial fixed-rate period—linked to a financial index. As the index rises or falls, the interest rate on the ARM is adjusted accordingly, which can affect the borrower's monthly payments.

This structure allows borrowers the potential benefit of lower initial rates compared to fixed-rate mortgages, but it also introduces the risk that payments may increase over time if interest rates rise. Understanding the connection between the index and the adjustments is crucial for borrowers when considering this type of mortgage, as it impacts their long-term financial planning.