Hybrid Option Adjustable Rate Mortgages: Is that really a loan product?

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Hybrid Option ARMs combine the features of traditional Option ARMs with hybrid ARMs, offering fixed rates and payments for short or medium terms like a hybrid ARM -- supplying more predictability and safety to the borrower while retaining the flexibility of a traditional Option ARM. These loans generally feature slightly higher minimum interest rates / minimum payments (leaving less chance for insurmountable negative amortization). Their fixed rates are built-in safety nets for borrowers, making them a safer alternative to traditional option ARMs. These loans come in three varieties characterized by the following terms:
  • Initial fixed rate period. The interest rate is fixed for the introductory period, after which it will adjust with market conditions, and be determined by an index plus a margin.
  • Initial fixed minimum payment period. The minimum payment is fixed for an initial period, after which the minimum payment can change annually. The underlying rate does move with market conditions and is calculated by adding an index to a margin.
  • An initial period in which both the rate and the minimum payment are fixed. This is the safest option.
Most hybrid option ARMs are like choice number 3, or a combination of choices 1 and 2. The goal is to make the loan safer for borrowers (and also lenders), while continuing to offer the desired flexibility that allows borrowers to manage their finances and lifestyles.

Here is how a typical 3/1 option ARM with a fixed rate and minimum payment works: For the first three years, the interest rate is fixed at 5.5%. The minimum payment might be fixed at three points below that, or 2.5%. So a borrower with a $300,000 mortgage might have the following payment options:
  • Minimum payment @ 2.5%        $1,185
  • Interest only payment @ 5.5%    $1,375
  • 40 year payment @ 5.5%        $1,547
  • 30 year payment @ 5.5%        $1,703
  • 15 year payment @ 5.5%        $2,451
Disadvantages:  Like all ARMs, there is a risk that the interest rate will adjust upwards when the introductory period ends. And if borrowers choose to avail themselves of the minimum rate for every payment there will be deferred interest (negative amortization) although it will be less than with a traditional Option ARM.

Advantages: Like an Option ARM, the hybrid Option ARM allows borrowers to manage their mortgages by giving them a selection of payments in varying amounts to pay each month. The safeguards in the form of higher minimum payments and an introductory fixed interest rate can prevent borrowers from owing too high a balance at a time when their interest rate is adjusting upwards. This prevents what became a major drawback with traditional Option ARMs--unprepared borrowers found themselves caught in a perfect storm of rising interest rates, a significantly higher loan balance, and less time to pay it off, resulting in sharply increased payments than some found unaffordable. The hybrid Option ARM can be thought of as an Option ARM with training wheels, offering both flexibility and safety.
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