Final answer:
An adjustable-rate mortgage (ARM) is a type of loan used to purchase a home in which the interest rate varies with market interest rates. Borrowers may initially benefit from lower interest rates compared to fixed-rate loans, but they are exposed to the risk of future rate increases.
Step-by-step explanation:
An adjustable-rate mortgage (ARM) is a type of loan that a borrower can use to purchase a home. The interest rate on an ARM varies with market interest rates, meaning it can increase or decrease over time. This is in contrast to a fixed-rate loan, where the interest rate remains the same throughout the loan term.
With an ARM, the borrower may initially receive a lower interest rate compared to a fixed-rate loan. However, because the interest rate is subject to change, the borrower bears the risk of potential rate increases in the future. This risk is often balanced by certain protections and limits on how much the interest rate can change.
For example, an ARM might have an initial fixed rate for a certain period, such as five years, after which the rate can adjust annually based on a pre-determined index plus a margin. The specific terms and adjustments of an ARM loan can vary depending on the lender and the terms agreed upon by the borrower.