Definition:
An adjustable-rate mortgage (ARM) is a home loan with an interest rate that periodically changes, usually based on a benchmark or index rate.

Example:
Suppose John takes out a 5/1 ARM loan. His mortgage has a fixed rate of 4% for the first five years, then adjusts annually based on market conditions. If interest rates rise after five years, John’s monthly payments could increase significantly.

Explanation:
In real estate, ARMs typically start with a lower introductory fixed rate for a set period (often 3, 5, or 7 years), after which the rate resets regularly (often annually). Rate adjustments depend on a predetermined financial index, such as the LIBOR or prime rate, plus a lender's margin. To protect borrowers, ARMs typically include caps limiting how much the interest rate or monthly payments can rise within each adjustment period and over the life of the loan.

Buyers may choose ARMs to benefit from initial low payments, especially if they plan to refinance or sell before the adjustable period begins.

Importance:
Understanding ARMs is critical because they carry inherent risks and benefits. Initially, borrowers benefit from lower interest rates and monthly payments compared to fixed-rate mortgages. However, future adjustments could substantially increase monthly costs, potentially leading to financial stress if interest rates rise significantly.

For homebuyers, awareness of ARM terms, adjustment periods, and caps is essential for managing risk and budgeting effectively. Sellers benefit from understanding ARMs when negotiating with buyers whose financing might rely on variable-rate loans.

In short, adjustable-rate mortgages can offer short-term affordability but require careful consideration due to their unpredictable nature over time.