Hybrid Adjustable Rate Mortgages

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A hybrid ARM is simply a combination of an adjustable rate mortgage (ARM) and a fixed rate mortgage (FRM). This popular loan choice features an introductory period in which the rate is fixed. Generally, the shorter the fixed rate period selected, the lower the rate. Most loans offer introductory fixed rates for the first 3, 5, 7, or 10 years of the loan. At the end of the introductory period, the new rate is calculated the same way as a regular ARM loan, using a published financial index plus a margin agreed to by the lender and borrower. This is called the fully-indexed rate.

Like regular ARM loans, Hybrid ARMs come with adjustment rate caps and lifetime rate caps. The difference is that there may be an additional cap: the first adjustment cap. For example, if a borrower selected a 3/1 hybrid ARM loan with a start rate of 4%, the rate would be fixed at 4% for the first 3 years, then the loan would convert to a 1 year ARM and adjust once a year. The first adjustment would be determined by the index (for example the 1 year Constant Maturity Treasury, or CMT, in this case assume it is at 2.71%) plus the lender's margin (assume in this example that it is 2.5%). So this loan would adjust from 4% to 5.21% (2.5% plus 2.71%). Typically, a first adjustment cap for a hybrid ARM is 3% -- so if the CMT happened to be at 6% instead of 2.71%, the rate would not jump to 8.5% -- the 3% cap would limit the new rate to 7%.

The rate on this loan could be adjusted each year, and the cap for these subsequent adjustments is usually 2%. In addition, hybrid ARMs come with lifetime caps. A lifetime cap of 5% means that this loan rate could never exceed 9% (start rate of 4% plus cap of 5%), regardless of what the CMT index does.

Disadvantages: This loan could be described as offering the best of both worlds--or the worst of both worlds. Interest rate risk cuts both ways here: If rates increase when the fixed rate period is over, the borrower could end up with significantly higher payments. And if rates drop while the borrower is in the fixed rate period, he or she would be unable to take advantage of that lower rate. So if the fixed rate period is too short in an increasing market, or too long in a decreasing one, borrowers could find themselves on the wrong side of a rate rebound.

Advantages: The loan offers a discount from 30 year fixed mortgage rates while providing a safety net of a fixed rate for the introductory period. And for many homeowners it makes little sense to pay for a fixed rate for thirty years when most will be out of their homes and loans long before then. In addition, borrowers seeking jumbo or super jumbo financing will likely find that hybrid ARMs offer them significant savings over 30 year fixed rate loans. Jumbo 30 year fixed rate mortgage rates are almost always quite a bit higher than conforming 30 year fixed rates, while jumbo hybrid ARM rates are generally lower than comparable ARMs in conforming loan amounts. Hybrid ARMs provide a combination of safety and savings that many homeowners find too attractive to pass up.

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