Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage has a rate that is fixed for an initial period and then resets periodically to a market index plus a margin. The lower starting rate often lifts early cash on cash return, but the return after the first reset depends on where rates go.

Suppose the default loan were an ARM at 7.25% for five years that then reset to 9.25%. The remaining balance of about $353,900 would be paid over 25 years at roughly $3,031 a month. Cash flow would drop from $9,512 to about $3,840, and cash on cash from 6.3% to about 2.6%.

Rate caps in the note limit how far each reset can go, so you can calculate the worst case before buying. A sensible test is to run the deal at the capped rate. If the return is still acceptable, the ARM's lower starting payment is a bonus rather than a bet.

Further reading: Adjustable-Rate Mortgage (ARM) on Wikipedia.