An ARM is a loan with an interest rate that changes at the scheduled adjustment date based on movements in an index rate, such as the rate for Treasury securities. ARMs usually offer a lower initial interest rate than fixed-rate loans. The interest rate fluctuates over the life of the loan based on market conditions, but the loan agreement generally sets maximum and minimum rates. When interest rates increase, generally your loan payments increase; and when interest rates decrease, your monthly payments may decrease. Depending on the type of ARM loan, the interest rate and monthly payment will change every month, quarter, year, three years, five, seven or ten years. The period between rate changes is called the adjustment period. For example, a loan with an adjustment period of one year is called a one-year ARM, because the interest rate and payment change once every year; a loan with a three-year adjustment period is called a three-year ARM.
Some ARMs have interest-rate caps and the cap may hold your rate and payment below what it would have been if the change in the index rate had been fully applied. Since the increase in the interest that was not imposed due to the rate cap the amount it could adjust to will carry over, at the next future rate adjustment, your payment might increase, even is the index rate has stayed the same or declined.