Final answer:
An adjustable-rate mortgage (ARM) is a loan with an interest rate that changes periodically in relation to an index. It is designed to protect lenders from inflation by linking interest rate adjustments to it. ARMs often provide lower initial rates than fixed-rate loans.
Step-by-step explanation:
An adjustable-rate mortgage (ARM) is a number that is adjusted at periodic intervals over the term of the loan. Changes are based on a predetermined formula and tied to an index. The index is a unit-free number derived from the price level over a number of years, making the process of computing inflation rates more manageable as it brings the index number to values around 100.
Loans often include inflation adjustments. For example, if the inflation rate rises by two percentage points, then the interest rate a financial institution charges on the loan also rises by two percentage points. This is to ensure that the lender is protected against the risk that higher inflation will erode the real value of loan payments. Thus, an ARM typically offers a lower initial interest rate compared to a fixed-rate loan because the lender's risk from inflation is mitigated.