What Is a Hybrid ARM?
A hybrid adjustable-rate mortgage, referred to as a hybrid ARM or “fixed-period ARM,” combines the features of a fixed-rate mortgage with those of an adjustable-rate mortgage. Initially, a hybrid ARM offers a fixed interest rate period, which transitions to an adjustable rate period. Once the fixed rate period expires, the rate adjusts based on an index plus a predetermined margin – a point known as the reset date.
A prevalent form of hybrid ARM is the 5/1 ARM, with an initial fixed term of 5 years, followed by adjustable rates resetting annually.
### Key Takeaways
- Hybrid adjustable-rate mortgages (ARMs) provide an initial fixed rate for a designated period, followed by annual interest rate adjustments.
- Upon transitioning to the adjustable phase, hybrid ARMs reset periodically, typically on an annual basis.
- While homeowners may benefit from lower mortgage payments during the initial phase, they risk higher rates post-reset.
- A popular form, the 5/1 hybrid ARM, entails a fixed initial five-year term with subsequent annual adjustments to a variable rate.
Understanding Hybrid ARMs
Conventional fixed-rate mortgages lock in a constant rate for the loan term, usually 15 or 30 years. Conversely, adjustable-rate mortgages (ARMs) possess fluctuating interest rates that reset periodically, potentially surpassing the initial rate.
Hybrid ARMs blend fixed and adjustable-rate characteristics by offering a fixed rate initially, followed by annual adjustments post the fixed-rate period. The duration of the initial fixed-rate tenure can vary, for instance, three, five, or seven years. Upon expiration of the fixed-rate period, the loan transforms into an adjustable-rate mortgage, resetting based on an index or benchmark.
#### Examples of Hybrid ARMs
A prevalent hybrid ARM variant is the 5/1 ARM, featuring a five-year fixed-rate period and annual rate resets thereafter. The “five” signifies the fixed-rate duration, while the “one” denotes the annual resetting frequency post the fixed term.
Various ARMs such as the 3/1, 7/1, and 10/1 share the same structure, with the first number representing the fixed rate period and the second number indicating the resetting frequency. Consequently, the 3/1, 7/1, and 10/1 ARMs provide an initial fixed rate for three, seven, or 10 years respectively, adjusting annually thereafter.
Additional ARM configurations like the 5/5 and 5/6 ARMs entail a five-year introductory period followed by rate adjustments every five years or every six months, respectively. Less common are variants like 2/28 and 3/27 ARMs, where the fixed rate is applicable for the initial two or three years, respectively, followed by adjustable rates. Some of these mortgages reset semi-annually rather than annually.
#### Risks of Hybrid ARMs
Borrowers must carefully assess their time horizon when opting for a hybrid ARM and understand the risks linked to the reset date or the end of the fixed-rate period. A significant interest rate change during the reset can escalate payments substantially.
Despite the potential interest rate adjustment, there’s usually an interest rate cap restricting the extent of the rate change. When selecting a hybrid ARM, ensure to partner with a lender well-versed in adjustable-rate mortgages to navigate the intricacies effectively.
### Hybrid ARM Risks
Hybrid ARMs pose risks, especially for borrowers planning to refinance or sell post-reset. Unforeseen circumstances like unemployment or market downturn may hinder the borrower’s ability to meet higher payments, ultimately leading to default or foreclosure.
How Hybrid ARMs Are Structured
Hybrid adjustable-rate mortgages offer fixed-rate terms of three, five, seven, or ten years, transitioning to adjustable rates post the reset. Following the reset, the mortgage interest rate typically undergoes annual evaluation.
While long-term 30-year fixed-rate mortgages present competitive low-interest rates, hybrid ARMs cater to homebuyers with diverse requirements. For individuals not planning to stay in a property for 30 years, mortgages with rates aligned with their expected duration may be more favorable.
Hybrid ARM adjustments factor in a margin added to a benchmark rate to determine the new rate post-reset. Several benchmarks exist with an interest rate floor, setting the lowest admissible rate adjustment. Likewise, a lookback period aids in calculating the new rate at the reset date.
The calculation of the new adjustable rate may include a lookback period where the lender considers the index within the determined period. The specific length of this period varies among lenders, typically around 45 days.
What Is the Difference Between an ARM and a Hybrid ARM?
An ARM adjusts rates periodically, while a hybrid ARM maintains a fixed rate initially, transitioning to annual adjustments post a set period. The fixed-rate term may span three, five, or seven years.
What Is a 5/1 ARM Loan?
A 5/1 adjustable-rate mortgage features a five-year fixed-rate period followed by annual resets. The “five” denotes the fixed-rate period, and the “one” indicates the annual resetting cycle post the fixed-term – once a year.
What Are the Risks to a Hybrid ARM?
If the borrower struggles with the new rate post-reset, defaulting on payments is a risk. Moreover, plans to sell the property post-reset amid reduced property value may result in financial loss if the property value dips below the outstanding loan amount.
The Bottom Line
Hybrid adjustable-rate mortgages offer a fixed rate during an initial introductory period, typically for several years. Post this phase, the loan’s interest rate adjusts annually based on market conditions or a benchmark. Consequently, the adjusted rate could significantly surpass the original fixed rate.
While borrowers benefit from lower monthly payments during the introductory phase, the reset feature of a hybrid ARM poses the risk of heightened post-reset interest rates. Thus, borrowers often consider refinancing to evade increased rates post-reset.