An adjustable rate mortgage (ARM) is a loan that bases its interest rate on an index. The index is typically the LIBOR rate, the Fed funds rate, or the 1-year Treasury bill.  An ARM is also known as an adjustable rate loan, variable rate mortgage, or variable rate loan.

Each lender decides how many points it will add to the index rate. It's typically several percentage points. For example, if the LIBOR rate is .5%, the ARM rate could be anywhere from 2.5% to 3.5%. Most lenders will keep the rate at that advertised rate for a certain period. Then the rate rises at regular intervals. This is known as a reset. It depends on the terms of the loan. It can occur monthly, quarterly, annually, every 3 years or every 5 years, depending on the type of loan you get. You've got to read the small print carefully to determine if you will be able to pay the higher interest rate.

After the reset, the rate will increase as LIBOR does. That means your money payment could suddenly skyrocket after the initial five-year period is up.

If LIBOR rose to 2.5% during that time, then your new interest rate would rise to 4.5% or 5.0%.

That means you've got to pay attention to changes in the Fed funds rate. That's because LIBOR typically changes in lockstep with those two rates. It can also vary alon with short-term Treasury bill yields. When demand for Treasuries falls, it forcing the yield up. See How U.S. Treasury Yields Work.

Pros

The advantage of adjustable rate mortgages is that the rate is lower than for fixed rate mortgages. Those rates are tied to the 10-year Treasury note. That means you can buy a bigger house for less. That's attractive to first-time homebuyers and others with low incomes.

Cons

The big disadvantage is that your monthly payment can skyrocket if interest rates rise. Many people are surprised when the interest rate resets, even though it's in the contract. If your income hasn't gone up, then you may no longer be able to afford your home, and could lose it.

Adjustable rate mortgages became popular in 2004, when the Federal Reserve began raising the Fed funds rate. Demand for conventional loans fell as interest rates rose. Banks created adjustable rate mortgages to make monthly payments lower. 

Types

In 2004, bankers got creative with new types of loans to entice potential homeowners. Here are some examples of the most popular.

Interest-only loans: They have the lowest rates. Your monthly payment just goes toward interest, and not any of the principle, for the first 3 - 5 years. After that, you start making higher payments to cover the principle. Or, you might you might be required to make a large balloon payment.

If you are aware of how they work, these loans can be very advantageous. If you can afford it, any extra payment goes directly toward the principle. If you are disciplined about making these payments, you can actually pay more against the principle. That way you will gain a higher equity in the home than with a conventional mortgage. These loans are dangerous if you aren't prepared for the adjustment or the balloon payment. They also have all the same disadvantages of any adjustable-rate mortgage.

Option ARMs: They allow borrowers to choose how much to pay each month. They start with "teaser" rates - about 1-2%. These can reset to a higher, even after the first payment. Most (80%) option ARM borrowers make only the minimum payment each month. The rest gets added to the balance of the mortgage - just like negative amortization loans. 

Borrowers think payments are fixed for five years. If the unpaid mortgage balance grows to 110% or 125% of the original value, the loan automatically resets. It can result in a payment that's three times the original amount. Steep penalties prevent borrowers from refinancing. As a result, most borrowers simply fall deeper into debt. Once the house is worth less than the mortgage, or the borrower loses a job, they foreclose.

These loans were a huge driver behind the subprime mortgage crisis. Although only two percent of all home loans were option ARMS, they were worth $300 billion - and most defaulted. At least 60% were in California, where home prices fell 30-40%. This disqualified them from taking advantage of home loan modification programs like MakingHomesAffordable.  (Source: "Toxic Mortgages," Center for Responsible Lending, November 5, 2007. "Nightmare Mortgages," Businessweek, September 11, 2006) Article updated October 21, 2015.