Final answer:
The two parts that make up the interest rate of an adjustable-rate mortgage (ARM) are market interest rates and the risk premium.
Step-by-step explanation:
Two parts that make up the interest rate of an adjustable-rate mortgage (ARM) are the market interest rates and the risk premium.
Market interest rates: The interest rate on an ARM is tied to a specified market interest rate index, such as the US Treasury rate or the London Interbank Offered Rate (LIBOR). As the market interest rates change, the interest rate on the ARM adjusts accordingly. For example, if the market interest rates increase by 1%, the interest rate on the ARM will also increase by 1%.
Risk premium: The risk premium is the additional interest charged by the lender to compensate for the risk associated with lending money. With an ARM, the lender is exposed to the risk that higher inflation may reduce the real loan payments. To offset this risk, the interest rate on an ARM includes a risk premium, which is typically lower than the risk premium on a fixed-rate loan.