Adjustable Rate Mortgages (ARMs) are a type of home loan where the interest rate can vary over time. They typically start with a fixed interest rate for an initial period, which can range from one month to ten years. After this initial period, the interest rate can adjust periodically based on market conditions.

One of the main advantages of ARMs is that they often have lower initial interest rates compared to fixed-rate mortgages. This lower rate can make it easier for homebuyers to afford a more expensive home or to qualify for a larger loan amount.

The adjustment of the interest rate on an ARM is determined by adding a margin to an index. The margin is a predetermined percentage that remains constant throughout the life of the loan, while the index is a financial indicator that fluctuates based on market conditions, such as the 1-Year Treasury Security or LIBOR.

When it's time for the interest rate to adjust, the new rate is calculated by adding the margin to the current value of the index. This new rate is then rounded to the nearest 1/8 of a percent and becomes the new interest rate for the next adjustment period.

It's important to note that ARMs have caps to limit how much the interest rate can increase or decrease. There are usually two types of caps: periodic caps, which limit how much the interest rate can change from one adjustment period to the next, and lifetime caps, which limit how much the interest rate can change over the life of the loan.

For example, a 3/1 ARM with an initial interest rate of 4%, a periodic cap of 2%, and a lifetime cap of 6% could have its interest rate adjusted to a maximum of 6% in the second year and could never exceed 10% over the life of the loan, even if market rates were to increase significantly.