Is an Adjustable Rate Hybrid Mortgage (ARM) Right for You?
Safe and Predictable Option
If you got caught up in any of the mortgage mess from the past 10 years, chances are you had some form of adjustable rate mortgage.
As a result of horrible underwriting guidelines, and even more horrible loan officers and lenders, adjustable rate mortgages got a bad rap.
These adjustable rate mortgages are now known as toxic loans. Many toxic loans also have a negative amortization feature to them that made the balance increase over time.
Those programs no longer exist. There are no longer any “toxic” mortgage programs available today, and that’s important to understand.
An adjustable rate hybrid mortgage is safe, predictable, and a great option for the right borrower.
The appeal of an adjustable rate hybrid mortgage is that you can usually lock in an interest rate that is lower than that of a 3o year fixed mortgage.
Most people have heard of an adjustable rate mortgage. This type of home loan is basically based on a moving “base” interest rate called an “index”.
Common indices are LIBOR (London Inter Bank Offered Rate), or U.S Treasury Bonds. On a traditional adjustable rate mortgage, there is a margin, that is added to the index. This combination is your fully indexed rate.
The adjustable part of an ARM mortgage is always calculated on the current value of the index rate. Your margin is fixed at the time that you get your loan and will not change throughout the term of the loan.
It is not uncommon for adjustable rate mortgages to have a “starting rate” that is lower than the fully indexed rate. The introductory rate is both the scariest, and the most predictable part of a hybrid ARM.
Adjustment Period and Adjustment Caps
The final things you need to know about an adjustable rate mortgage are the adjustment period, and adjustment caps.
The adjustment period is how often your rate can “recalculate”, which is basically the current index, plus the fixed margin. Most hybrid ARM loans will adjust once a year after the fixed period.
Adjustment caps will tell you how much your rate can adjust either up, or down, at each adjustment period. A standard adjustment cap may be a maximum adjustment of 2% on the initial change, and no more than 1% a year after that.
During the mortgage industry crash of the past 10 years, adjustable rate indices dropped to next to nothing. What got most people in trouble were the crazy high margins that lenders were adding to the index.
Using today’s adjustable rate hybrid arm mortgages, you’re almost as likely for the rate to go down as it is to go up after the adjustment period.
What is a Hybrid ARM?
A hybrid adjustable rate mortgage is basically a fixed period where your interest rate and payments are fixed until a pre-specified term that you agree upon at the time you take out the loan.
A hybrid ARM is fixed for a period of either 3, 5, 7 or 10 years
Adjustable rate hybrid mortgages are also referred to as 3/1 ARM, 5/1 ARM, 7/1 ARM, or 10/1 ARM. The first number is how many years the rate is fixed. The second number is how often it can adjust once the fixed period is over.
Commonly thrown around statistics say that 90% of all mortgages are paid off, or refinanced in 9 years or less.
I would normally then refer to the statistic that 80% of the time statistics are made up on the spot to influence a specific response….but my experience as a lender would say that the 90% in 9 years is probably pretty accurate.
If you are buying your first home, a hybrid ARM is a great option for keeping your payments low for the first few years until you build equity, or advance in your career and start making more money.
If you have less than a 20% down payment, an adjustable rate hybrid mortgage will allow you to keep the payments lower to offset the mortgage insurance payment.
After 3, 5, or 7 years, you are going to most likely want to try to refinance that loan to remove your mortgage insurance. This is where you really benefit from a hybrid mortgage, and this is usually why people refinance within 7 to 9 years of buying.
How Do I know If It’s Right For Me?
There are many reasons why a hybrid ARM is a great option. Some of the most common reasons include:
- Planning on growing, or shrinking family in next 5 to 10 years
- Planning on moving in the next 5 to 10 years
- Home prices are rising quickly, and you need to keep your payments down
- You know you will refinance inside of the next 10 years to remove mortgage insurance
- You know you will refinance inside of the next 10 years to take cash out
- You know you will refinance inside of the next 10 years to reduce the term of the loan
Risks of Taking An Adjustable Mortgage
There are many potential risks you could encounter by taking an adjustable mortgage:
- Home equity could stay the same
- Home equity could go down as was the case during the mortgage crisis
- Adjustable rates could go higher (which they are doing now)
After the mortgage crisis. Home values fell, but so did the indices that were the basis for adjustable rate mortgages. Many homeowners that had responsible hybrid ARM mortgages during this time saw a significant drop in interest rates during this time.
I don’t think we are in that type of a market now, and I think that the smart move is to take advantage of the low fixed rate period now, in anticipation of having to refinance once the adjustment period starts.
While there are risks, these are not risky loans. These are smart loans. If you’re making an informed decision, and consider all of your options carefully, an adjustable rate hybrid loan might be the best option for you.
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