Hybrid ARM: Hybrid Adjustable Rate Mortgages in Home Loans
What is a Hybrid ARM?
Owning a home is a dream for many people. For some, saving up a down payment, going to a lender, and getting a conventional home loan is a relatively easy process. But for many others, the challenges to meet the demands of a conventional mortgage are daunting. You might make enough money to afford a mortgage and all the other expenses that come with home ownership, but your debt-to-income ratio may still be a little bit too high. For people in this situation, specialty loans such as a hybrid ARM can help speed up the path to home ownership.
Hybrid ARM Defined
Adjustable-rate mortgages (ARMs) have been around for years. In an earlier iteration, the interest rate would remain fixed and low for a period of three or five years, then adjust at a rate determined and agreed upon by the lender and the buyer. The rate would adjust up or down, and that would increase or decrease the monthly payment. These loans wreaked havoc on some homeowners because interest-rate increases often took a manageable mortgage payment and made it too expensive. This was especially true during the housing market crash in the mid-to-late 2000’s.
Structure of a Hybrid ARM
A hybrid ARM gives you a lower rate at the outset, making it a great choice for people who are having trouble income-qualifying for a mortgage. Initially, the rate is often lower than for similar fixed-rate products. After that, the interest rate will increase only at set intervals and is capped at both the top and the bottom. Hybrid ARMs offer the benefit of a lower mortgage payment for the first few years with a more gradual increase in interest, guaranteed to not leave a particular rate window, say between 3.25 and 7%.
Fixed Rate, Adjustable Rate, and Reset Date
For the sake of this post, we’re going to assume a 30-year loan for $200,000 with a $40,000 down payment, and a seven-year fixed rate of 4.51%, with one interest rate increase starting in year eight.
To understand how a hybrid adjustable-rate mortgage works, you need to understand the key terms. You probably already know that the principal is the amount of the loan, in this case, $160,000 since $40,000 is being used as a down payment. And you most likely understand that interest is the amount a lender charges for loaning you the money. The mortgage has a seven-year ARM with a fixed rate. This means that for the first seven years of the mortgage, the principal plus interest (P + I) payment will not change—though any escrows, including your taxes and homeowners insurance, may. Your interest rate will remain 4.51% for the first seven years, period, with no exceptions.
When you reach year eight, your interest rate will increase based on a specific rate index. There are several different indexes a lender might use. Some of the indexes include:
Weekly constant maturity yield on one-year Treasury bill. The yield that debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board.
11th District Cost of Funds Index (COFI). This index is based on the interest that financial institutions in the western part of the United States pay on held deposits.
London Interbank Offered Rate (Libor). This is the rate that international banks charge each other for large loans. This index will be phased out by the end of 2021.
Your lender will tell you which index it will follow to set your adjustable rate. The date this adjustment occurs is called the reset date.
Calculating the Adjustable Rate
The adjustable rate has two parts. First, when you initially take out the mortgage, your lender will set a margin. This is basically the base interest rate for your adjustable rate once your fixed rate ends.
For example, if your lender sets a margin of four, then your base interest rate is 4%. The other part of your adjustable rate is the index percentage. This is the “adjustable” part of your adjustable rate. Let’s say the index calculates a 1.50% increase for your interest rate. This means your mortgage payment will increase because your interest rate will increase from the 4.51% fixed rate to the 5.50% adjusted rate.
From year nine going forward, your interest rate will continue to increase according to the index calculation, once a year on the reset date. These increases will continue until you reach your interest cap, which traditionally is no more than five percentage points over your initial interest rate. The interest cap can vary, so confirm this information before you sign anything.
When the cap is 5%, like in this case, 9.51% is the maximum interest rate for this loan. If you plug these numbers into an amortization calculator, you’ll see that your initial P + I portion of your mortgage payment is $811.65 with steady increases until it maxes out at $1,202.99 at the start of year 16.
At this point, the interest cap kicks in and this is the P + I payment you’ll have for the duration of the mortgage unless rates decrease again. This, of course, is subject to change with the index, so you could reach the cap earlier or later, depending on how the index fluctuates.
Although hybrid ARMs do have interest caps, you’ll want to consider the time horizon for your mortgage. In our example, the first time horizon is seven years, which corresponds to the length of time you have the fixed interest rate and your lowest mortgage payments.
If you intend to sell the home before your fixed-rate period ends, then you should be working toward that goal. But if you plan to stay put for longer than the fixed-rate period, you’ll want to pay close attention to the index your lender will use to calculate your new interest rate.
Increases in the indexes are typically on the smaller scale. But it is conceivable that the index could take a sharp rise, which could take your manageable payment and make it impossible. Keeping an eye on the index will let you know how much of an increase you can expect. Your mortgage going from $830 to $900 is one thing, but having it increase to $1,000 or more in one year might cause an issue.
Can I save money on the adjustable-rate part of a hybrid ARM if interest rates fall?
Theoretically, yes. If the market index rate on which your hybrid ARM is calculated falls, you could actually be left with a lower interest rate than you had on the fixed-rate portion of your loan -- but that doesn’t always happen.
Plus, even if the market index rate decreases, you’re not going to get your mortgage for free. In addition to having caps that dictate how much and how fast your mortgage can increase, most hybrid ARMs also have a low-interest rate limit, called a floor. For example, if the floor for your hybrid ARM is 2.5%, that’s the lowest rate you’ll be able to pay, even if interest rates were to go down to zero.
Knowing whether a hybrid adjustable-rate mortgage is right for you depends on several factors. Consider these questions before making a 30-year commitment:
Do you anticipate increases in your income?
If you’re in law school, in medical school, or working toward another kind of advanced degree, do you anticipate this will lead to a substantial increase in your income? If you expect to be making much more as you finish school and progress in your career, a hybrid ARM could work for you since you won’t be as worried about a higher interest rate increasing your mortgage payment.
Do you plan to sell or stay put?
If you're looking for a starter home and anticipate selling and moving into a larger home, then having a mortgage with a lower payment for the first few years makes sense. If you plan to stay put but anticipate that your income will grow to cover the increased mortgage payments, then an ARM is a viable option.
How is your credit?
The higher your credit score, the better your interest rate, regardless of the type of loan.
But for a hybrid ARM, the higher your credit score, the lower the margin a lender might be willing to offer. And as we discussed above, that base number is very important.
Are you willing to refinance?
If the anticipated interest-rate increase might create a payment that could be hard for you to navigate but you want to stay in your home, you could refinance. You’ll want to pay on your mortgage until you’ve accumulated enough equity to cover the limited expenses of the refinance, but ultimately the payments could be lower and less of a strain on your budget. If refinancing is something you’re willing to consider further down the road, then starting out with a hybrid ARM could get you in a home quicker.
Other than student loans, a mortgage is often the largest expense a person will take on during their lifetime. Choosing the right type of mortgage is important because it could become a commitment that lasts several decades. If you can correct the defects keeping you from landing a conventional mortgage, you might reap a few advantages.
Because your interest rate for a conventional mortgage will be fixed and most likely lower than the rate for an ARM for the duration of your loan, you’ll pay less for the privilege of borrowing the money. It also means you will owe less. But if you don’t want to wait until you qualify for a conventional mortgage, or your dream house just happens to land on the market before you’re totally ready, then a hybrid adjustable-rate mortgage could be the solution you’re seeking.