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What Is a Hybrid ARM & What Are Its Pros & Cons?
Buying a Home

What Is a Hybrid ARM?

Sep 7, 2018, 10:08 AM | Logan Arey
A beautiful home that has been purchased using a hybrid ARM loan

A hybrid mortgage, typically known as a hybrid ARM, combines the features of both an adjustable rate mortgage and a fixed rate mortgage.

Hybrid mortgages start with a fixed rate period and end with an adjustable rate for the remaining life of the loan. The length of the fixed rate period depends on the type of loan you take out with your lender.

Why You Should Consider a Hybrid Mortgage

One major benefit of taking out a hybrid mortgage is that your interest rates are lower during the fixed rate period. This is because you demonstrate to your lender that you'll assume more risk after your fixed rate period is up.

Disadvantages

The main disadvantage of a hybrid mortgage is that your interest rate could potentially increase when your fixed rate period is up and you're at the will of the market. After your fixed rate period, your interest rates will adjust annually and will be based off of market indexes.

When to Consider a Hybrid Mortgage

A hybrid mortgage is a lot riskier than a fixed rate mortgage, but there are some key features to the loan that could benefit you if one of the following is true:

  • You Plan on Selling — How long do you plan on staying in your home? If you only plan on staying for a brief period of time, then a hybrid mortgage could be the right choice. Since your interest rates are lower than a fixed rate mortgage, you can take advantage of the low monthly payments and sell your home before your fixed rate period ends.
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  • You Plan on Refinancing — The same idea works if you plan to refinance your mortgage. Take advantage of the low interest rates and low monthly payments before refinancing.
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  • You Anticipate an Increase in Income — If you expect your income to increase and plan to be able to make the higher payments in the future, then you can still take advantage of the low fixed rate period and save money. And after the fixed rate period ends, the market could work in your favor.

Types of Hybrid Mortgages

You'll see hybrid mortgages expressed in two numbers like this: 3/1. The first number indicates how many years you'll have a fixed rate while the second number shows how often your rate will be adjusted. So, for this example, you would have a fixed rate for three years. Then, after that, your rate will be adjusted annually (once per year).

Fixed-rate periods vary and these are your typical options:

  • 3/1 — Three year fixed, adjusts annually
  • 5/1 — Five year fixed, adjusts annually
  • 7/1 — Seven year fixed, adjusts annually
  • 10/1 — Ten year fixed, adjusts annually

3 Things You Need to Know Before Considering a Hybrid Mortgage

There are three numbers that will determine what your monthly payment will be and they are expressed as indexes, margins, and caps.

1. Indexes

Indexes are the interest rates that are set by the market, and they are the ones that fluctuate over time. You'll see the index tied to one of these markets:

  • LIBOR (London Interbank Offered Rate)
  • COFI (11 District Cost of Funds)
  • T-Bill (US Treasury Bill)
  • CMT (Constant Maturity Treasury)
  • Fannie Mae 30/60
  • Federal Funds Rate
  • The Prime Rate
  • Monthly Treasury Average Index (MTA)

Will it matter who your index is tied to? The answer is yes.

LIBOR, for instance, publishes their index rates every month, which means when your adjustment period comes up it will reflect the most recent month that LIBOR publishes.

The MTA uses a moving average calculation, so it has a lag effect. For example, if interest rates are expected to rise, then an index tied to the MTA might be a little more economical because the index lags behind.

While it's important to consider which market your index is tied to, it's also worthy of note that indexes are not the only deciding factor in your monthly payment.

2. Margins

Margins are the percentage points that your lender ties to the loan. Indexes fluctuate, but margins stay consistent for the life of your loan and can be negotiated with your lender.

Adding the index and margin will give you your fully indexed rate. For example, you could have a loan with an index of 4% and a margin of 2%. This creates a fully indexed rate of 6%.

Say the next year your index drops down to 2%. With the margin remaining consistent at 2%, your new fully indexed rate drops down from 6% to 4%.

3. Caps

Caps are set in place to limit the amount your interest rate can increase or decrease. For example, if you have an interest rate cap of 2% and the index rises to 3% at the time of your adjustment, that means you'll only pay the 2%.

This is known as a periodic cap. In this example, you'll have a 2% cap every time you have an adjustment period.

One important thing to note about caps, however, is what is called carryovers. While caps are put in place for security purposes, they won't always lower your monthly payment.

Let's use the example above again. The index increases to 3% and you only pay 2% of it. That remaining 1% carries over to your next adjustment period. So if the index decreases at the time of your adjustment period, your monthly payment won't go down because you'll be paying for that 1% that wasn't paid for during the last adjustment period.

Here are a couple of other caps to know about:

  1. Lifetime Cap — By law, all hybrid mortgages have a lifetime cap and this will be a larger number. For example, you could have a lifetime cap of 5%. This means that during the life of the loan, the interest won't exceed 5%.
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  3. Payment Cap — The payment cap sets a limit on your monthly payment. These are good for individuals who are concerned about increasing monthly payments.

The way carryovers work with the payment cap is that you'll have an interest rate cap for your monthly payments.

Let's say your cap is 7.5% and your monthly payment is $1,000. This means that for your next adjustment rate, your monthly payments won't exceed $1,075. But whatever interest isn't paid for will be added to your total loan amount, which can lead to negative amortization.

Why a Hybrid Mortgage Might Be Right for You

To recap, think about your long-term goals. You can take advantage of the low interests rates and low monthly payments during your fixed rate period if you plan on selling your house or refinancing.

You could also take the risk of the market working in your favor. Again, you can't count on that, but interest rates have been lower in recent years. You can always plan for the higher payments, and if the market shifts in your favor, then you can benefit from it.

If you have any questions or concerns regarding a hybrid mortgage, you can contact us here at Elevate Mortgage. We're here to help you plan your future.

Logan Arey