Hybrid ARMs: Hybrid Adjustable Rate Mortgages

When you shop for a home loan, there are so many options that can be overwhelming. If you are in the market for a home loan and not planning to reside in your home indefinitely, then a hybrid adjustable rate mortgage (ARM) loan might hold your appeal. This type of mortgage products has gained increasing popularity in recent years.

In fact, you should be aware that hybrid ARMs are often advertised as 3/1 or 5/1 ARMs in today’s lending market. Of course, you might also see ads for 7/1 or 10/1 ARMs. But, what is exactly a hybrid adjustable rate mortgage (ARM)?

A hybrid adjustable rate mortgage, also known as a fixed-period ARM, features a combination of a fixed-rate period and an adjustable rate period. That is to say, these mortgage loans come with an interest rate that is fixed for an initial period of time and after the fixed period, the interest rate is subject to periodic adjustments.

The “hybrid” just refers to a mix of fixed-rate and adjustable-rate characteristics. For example, 5/1 is for an ARM with a 5-year fixed interest rate period and subsequent 1-year interest-rate adjustment periods, while 3/1 is for an ARM with a 3-year fixed interest rate period and subsequent 1-year interest-rate adjustment periods.

Bear in mind that these mortgages are usually based on a 30-year amortization. So, if you see ads for 5/25 or 3/27 ARMs, just to name a few, you should know that the first number tells you how long the fixed interest-rate period will be, while the second number tells you how many years the rates on the loan will be adjustable. For instance, 3/27 means it is a 30-year mortgage loan, with a 3-year fixed interest rate period and the remaining 27 years adjustable.

If these mortgages adjust every 12 months, they are exactly the same as 5/1 ARMs or 3/1 ARMs. Of course, be aware that these programs may also adjust every 6 months. Speaking of adjusting every 6 months, there are also programs advertised as 5/6 ARMs, which mean the loans feature a 5-year fixed interest rate period and subsequent 6-month interest-rate adjustment periods for the remaining 25 years.

Anyway, I would like to say that 5/1 hybrid ARMs are the most popular loan products offered by lenders. The second most popular loans among lenders are the 3/1 hybrid ARMs. According to a Freddie Mac survey in 1999, at least 75% of the lenders offered 5/1 ARMs and at least 60% offered other types of hybrid ARMs. Today, almost all mortgage lenders have hybrid ARM (especially 5/1 ARMs) on offer.

But, what happens to the interest rate during the adjustment periods? Just like ordinary adjustable rate mortgages, the index and margin are used to determine the interest rate and adjustments for hybrid ARMs.

The index refers to a measure of certain interest rates and the changes in an index rate determine the increase or decrease in ARM interest rates. In general, if the index moves up, your interest rate will go up as well. According to the Federal Reserve Board, lenders base the ARM index on a variety of indexes, such as Treasury Bills and LIBOR (London Interbank Offered Rate). For most hybrid ARMs that adjust on a yearly basis, the index of the 1-year Treasury bill is usually used.

As for the margin, it is a fixed number that is added to the index to create your mortgage rate during the adjustment periods. Based on the cost of the mortgage, most hybrid ARMs have a margin of 2.25% to 2.75%.

You know your mortgage rate will adjust at the reset day if the index has changed. The reset date is the date when the fixed-rate payment schedule for a hybrid ARM shifts to an adjusting payment schedule. Your lender will inform you of the index rate and your new mortgage rate. They will also re-calculate your principal and interest payment and inform you of the new mortgage payment.

In fact, in addition to index and margin rates, all adjustable rate mortgages (including hybrid ARMs) also have a cap. The cap is used to limit how much your interest rate or monthly payment can increase during each adjustment or over the life of the loan.

Most ARMs have an annual cap of 2%. This means if your mortgage rate this year is 4.5%, your mortgage rate cannot exceed 6.5% (4.5% + 2%) next year. Concerning the lifetime cap, it is typically 5% above the initial fixed rate. For example, if your initial rate is 3.5%, your mortgage rate cannot exceed 8.5% for the life of the loan.

Why so many consumers prefer hybrid ARMs? This is mainly because their lower initial rates. Initially, whether for 3/1, 5/1, 7/1 or 10/1 ARMs, borrowers would enjoy a lower interest rate compared to fixed-rate mortgages. Be noted that 3/1 ARMs may come with the lowest initial rate. However, if you want a lower interest rate, but are also concerned about possible interest hikes that might occur during adjustment periods, you can choose a 10-year ARM loan.

Anyway, you should beware of ARM mortgages with low introductory rates because the interest rate will probably adjust to the market rate after the introductory period. According to the Federal Reserve, some lenders offer a tease rate, which is very lower in the initial fixed period.

However, this rate can rise greatly after the introductory period. So, when shopping for a hybrid ARM, you should look at the annual percentage rate or APR, instead of just looking at the initial rate and monthly payments. If the APR is much higher than the initial rate, then you could expect your rate and payments to be much higher after the loan adjusts.