Final answer:
An adjustable-rate mortgage (ARM) is a home loan with an interest rate that varies based on market conditions and can change over time. Important terms of an ARM include the initial interest rate, adjustment period, interest rate cap, index rate, and margin. Pricing an ARM involves setting these terms based on market conditions and the involved parties' risk.
Step-by-step explanation:
An adjustable-rate mortgage (ARM) is a home loan with an interest rate that can change periodically. This means the monthly payments can go up or down. Generally, the initial interest rate is lower than that of a comparable fixed-rate mortgage. After that period ends, interest rates — and your monthly payments — can go lower or higher.
There are several terms likely to be negotiated in an ARM, including:
- Initial interest rate - This is the starting rate of the ARM, which is typically lower than fixed-rate mortgages.
- Adjustment period - The length of time between interest rate changes.
- Interest rate cap - The limit on how much the interest rate can change during each adjustment period or over the life of the loan.
- Index rate - A benchmark interest rate to which the ARM is tied. The ARM's interest rate will change with this index.
- Margin - The number of percentage points the lender adds to the index rate to determine the ARM's interest rate.
'Pricing an ARM' means setting these terms in a way that reflects current market conditions, the borrower's creditworthiness, and the lender’s risk tolerance.
Loans often have built-in inflation adjustments, meaning if inflation rises, so does the interest rate. With an ARM, the lender is guarded against the risk that inflation will lower real loan payments. Hence, the initial interest rate for an ARM can be lower, as the risk premium part of the interest rate is lower. If the inflation rate rises by two percentage points, the interest rate on the loan may rise correspondingly.