Final answer:
An ARM contains an index and margin which allows the interest to adjust over the loan term. It can be advantageous for borrowers due to initially lower interest rates and is a means for lenders to adjust interest rates in response to market changes or inflation.
Step-by-step explanation:
An Adjustable Rate Mortgage (ARM) contains a index and margin that allows the interest to adjust over the loan term. An ARM is a type of loan used to purchase a home in which the interest rate varies, typically with market interest rates or the rate of inflation. The attribute that permits this flexibility is called an escalation provision. However, in the context of an ARM specifically, the mechanism allowing for the adjustment of the interest rate is a combination of an index to track changes in market interest rates and a margin, which is set by the lender.
The advantage for borrowers opting for an ARM usually arises from the initial lower interest rates compared to fixed-rate loans. This aspect makes ARMs particularly attractive when the borrower anticipates decreases in rates or short-term homeownership. Lenders are compensated for the potential risk of increasing inflation with the ARM's flexibility, allowing them to adjust rates and maintain an appropriate level of return on the loan.