How does an adjustable-rate mortgage (ARM) function?

An adjustable-rate mortgage (ARM) functions by having an interest rate that fluctuates based on prevailing economic conditions. Typically, the interest rate is linked to a specific financial index, which reflects the overall market interest rates. As these rates change, so does the interest rate on the mortgage, usually after an initial fixed-rate period. This means that borrowers may benefit from lower rates in a declining interest rate environment, but they also face the risk of higher payments if rates rise.

The adjustable nature of the interest rate distinguishes ARMs from fixed-rate mortgages, where the rate is constant throughout the loan's life. Additionally, while a borrower's credit score can influence the terms and eligibility for a loan, it does not directly affect how ARMs operate. Furthermore, while lenders do have some discretion regarding loan terms, they cannot arbitrarily set interest rates without considering relevant economic indices used as benchmarks for ARMs.