Hybrid ARMs: How Do They Work?

March 30th, 2010

As the housing market slowly stabilizes in different regions of the country, one trend that is emerging is the increase in mortgage applications for hybrid ARMs. Combining advantages of fixed rate mortgages and adjustable-rate mortgages (ARMs), hybrids allow flexibility and stability.

But how do they work, exactly?

Initial Fixed-Rate Period

Hybrid ARMs have an initial period during which the interest rate is fixed. For example, a 3/1 ARM has an initial mortgage rate that is fixed for three years. A 5/1 ARM has the initial rate fixed for five years, a 7/1 ARM for seven, and a 10/1 ARM for ten. During this initial period, your home mortgage is just like any fixed-rate mortgage.

Adjustment Period

After the initial fixed-rate period ends, your mortgage rate can (and probably will) adjust. In a hybrid ARM, the mortgage rate can adjust every year (the “1″ in 3/1, 5/1, etc., indicates an annual adjustment) on the anniversary date of the mortgage closing. During the year, your mortgage rate will remain fixed.

How the Mortgage Rate Adjusts

Adjustable-rate mortgages have two components that determine their interest rate during the adjustment periods. The first component is the adjustable component, the index. The index used for an ARM must be one that is easily found by the borrower, published in the business section of daily newspapers, or found with an easy Internet search. For most hybrid ARMs that adjust annually, the index is the 1-year Treasury bill. The rate reflects the interest rate the United States government pays to borrow money for 1-year periods.

The second component of the adjustable rate mortgage is the margin. The margin is a fixed number that is added to the index to create your mortgage rate during the adjustment period. Standard for most hybrid ARMs is a margin of 2.25% to 2.75%, depending on the cost of the mortgage.

Every year on the anniversary date of the funding of your hybrid ARM after your initial fixed rate period, your mortgage rate can adjust if the index has changed. The lender will notify you of the rate of the index, add the margin, and notify you of the new mortgage rate. The lender will also recalculate your principal and interest payments and notify you of the new mortgage payment.

For example, if you funded a 5/1 hybrid ARM in 2005 and your first adjustment begins with your April 1, 2010 payment, your lender would notify you at least 30 days in advance of the adjustment. With the 1-year Treasury bill index at 0.440% and a margin of 2.5%, your new mortgage rate for the year is 2.94%.

Mortgage Rate Caps

All adjustable-rate mortgages–both regular ARMs and hybrid ARMs–have caps on how high the mortgage rate can adjust each time and for the life of the loan. Most annual caps on ARMs are 2% per year, meaning if your mortgage rate this year is 3.5%, next year your mortgage rate cannot exceed 5.5%. The lifetime cap is the maximum mortgage rate your ARM can ever have. Typical, this lifetime cap is 5% above the initial fixed rate–so if your initial rate is 4.25%, over the life of the loan, your mortgage rate can never exceed 9.25%.

Hybrid ARMs are not for everyone, but they do serve a purpose for many mortgage applicants looking for a refinance mortgage or a purchase mortgage. Before submitting your mortgage application, make sure you know how this type of mortgage works.

Posted By :
Dennis C. Smith is co-owner and broker of record for Stratis Financial in southern California. He has over twenty years' experience in the mortgage industry.

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