As the economy stabilizes and lenders are becoming more flexible, the popularity of the hybrid adjustable rate mortgage (hybrid ARM) is increasing once again. It offers home buyers the opportunity to purchase a home affordably and to save on interest, at least initially. However, it brings considerable risk as well. Use this guide to evaluate the level of risk associated with this type of loan and to decide whether you are willing and able to bear this risk.
How a Hybrid ARM Works
With a hybrid adjustable rate mortgage, the interest rate is initially fixed for a set period of time. This period is usually 3, 5, 7 or 10 years. After this period expires, the interest rate becomes variable for the remainder of the term. The typical hybrid loan has a term of 30 years.
The initial fixed rate is typically much lower than that on a 30-year fixed rate loan. Currently, it is 1% lower. This percentage may not be impressive, but with interest which is just 1% lower, you can save over $150 every month.
After the initial fixed-rate period expires, the interest will be adjusted annually based on an index. This index is typically LIBOR or Treasury/CMT. Since the index can go up and down, the interest can also go up and down. It is not mandatory for it to go up due to the adjustment. However, the lender will typically add a margin which is around 2.5%. This means that you will have to pay higher than the initial rate anyway, unless the index falls with more than 2.5% and cancels out the increase. Of course, this last scenario is highly unlikely.
The adjustable rate cannot increase or decrease endlessly. There are several adjustment caps which keep it within set limits and which are designed to protect the borrower. There is an initial adjustment cap, an annual adjustment cap and a lifetime cap.
Risk and Exit Strategies
The risk of default on a hybrid adjustable rate mortgage is higher for several reasons. Firstly, after the initial period, the rate can rise so much that you will no longer be able to repay the loan. Issues can arise from the constant fluctuations as well. In this case, it will be more difficult for you to plan your spending. If you have just invested in a major home improvement and the interest rate increases unexpectedly, you may be left struggling to repay your home loan.
There are two main strategies which people can use to exploit the initial lower fixed rate and to avoid the higher adjustable one. The primary one is to sell the house and to get a new mortgage. It seems easy and simple, but this is not necessarily the case. It may take more than a year for a property to be sold. Furthermore, a new home loan may be much more expensive and possibly unaffordable.
Refinancing is also an option, but it may be difficult to qualify if you do not have much equity in the property. Besides, you can never be certain that you will actually get better terms with refinancing and save.
Overall, the hybrid adjustable rate mortgage is quite risky. The only way to offset the risk is to have sufficient income for making the higher payments.