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THE HYBRID

One variation of an ARM — known as a “hybrid” — is a cross between a fixed rate and an adjustable rate. The loan is fixed for the first few years at a predetermined rate and term; and then it turns into an annual or six-month ARM.

Hybrids start out slightly higher than an ARM but lower than a fixed rate. It's a “tweener.”

Because it is an ARM, the hybrid has an index, a margin, and caps, but it doesn't adjust until after the initial fixed period.

Hybrids have different names based on the length of the fixed period and what the rate will adjust to. For example, a 3/1 ARM means the ARM is fixed for three years, then turns into a one-year ARM. A 5/1 ARM means the ARM is fixed for five years, then turns into a one-year ARM.

A twist is the 5/6 ARM. At first glance one would think that this hybrid is fixed for five years, then adjusts every six years. But in reality if s fixed for five years, then adjusts every six months.

There are 3/1, 5/1, 7/1, and even IO/i hybrids. And there can be 3/6, 5/6, 7/6, and IO/6 hybrids, although the most common are the 3Д and 5Д and the 3/6 and 5/6.

Hybrids, like their ARM cousins, have both adjustment and lifetime caps. Caps on both hybrids and ARMs are expressed as a series of numbers such as 2/1/6 or 2/2/6.

The first number is the percentage cap for the first adjustment; the second number is the annual or semiannual cap; and the last number is the lifetime cap. For a 2/1/6, the initial cap of 2 percent above the original start rate adjusts annually (one year) and has a 6 percent lifetime cap.

Adjustments occur when the fixed-rate period expires and the hybrid performs like an ordinary ARM. For instance, on a 3/6 hybrid, at the end of three years the loan would take the index, add the margin to it, and then reset for the following six months, with the caps limiting the adjustment up or down.

Why would anyone choose an ARM? ARMs typically come with an initial start rate, or a “teaser” rate that can be i to 2 percent lower than the fully indexed rate (the rate arrived at by adding the index and the margin).

This is to entice the consumer to select an ARM over a fixed rate because of the ARM's lower starting rate. Lenders like ARMs. And why wouldn't they? As interest rates change over the course of the years, the ARM is tied to the current costs of money, plus a margin over that. As rates fluctuate, ARMs fluctuate with them, with the lender less likely to lose money over the term of the loan.

With a fixed rate, the rate is locked in until the note is retired.

So which is best for you — a fixed-rate mortgage, an ARM, or a hybrid? There are two things to consider current market rates and how long you intend to keep the property.

Interest rates change over the course of months and years. Sometimes they'll be relatively high and sometimes they'll be historically low. In the early 1980s, for instance, mortgage rates were around 20 percent! Twenty years later, they hit historical lows in the 5 percent range.

By comparing current market rates with historical rates, you can determine if the market is at a relative high, a relative low, or somewhere in the middle. You can find historical rate charts on the Internet. Personally, I visit hsh.com when I want to look at various indexes and rate trends.

Simply, if rates are relatively high, you may want to take an ARM. And if rates are relatively low, you'd want to lock in those low rates for the long term, so you'd select a fixed rate.

You would select an ARM because its initial teaser rate is lower than the current fixed rate offerings — and because the ARM's rate will adjust downward as interest rates move lower. Then — if you plan on owning the property and keeping the mortgage long term — when rates hit rock bottom you would refinance that note into a fixed-rate mortgage.

If you don't plan to keep the property for more than a few years, you should consider either an ARM or a hybrid. People take these loans when they're fairly certain they'll be transferred and will have to sell the property in the short term.

For instance, say you know you're going to be transferred in four years and you want to own, not rent. You may want to consider a 5/i ARM with a lower start rate than a fixed one. Your payments would be lower and you wouldn't have to worry about a reset because, according to your plans, you would have sold the condo before the initial fixed-rate period expires.

When you're deciding between an ARM and a hybrid, you need to compare both programs over the projected time frame during which you would own the home. Let's look at an example — a $250,000 loan with a 5/1 hybrid at 5.75 percent and a one-year ARM based on the one-year Treasury bill with a teaser rate of 4.75 percent, 2 percent annual caps, and a 2.75 margin. And let's assume a worst-case scenario: that you will hit the 2 percent annual cap at each reset.

Year

ARM

Hybrid ARM

Savings (annual)

1

$1,304

$1,458

$1,848

2

$1,621

$1,458

($2,724)

Did you see what happened? All gains won by the ARM during the first year were wiped out by losses in the second year. Granted, we did play the worst-case scenario, where the fully indexed rate would “cap out” and go from 4.75 percent to 6.75 percent. But the risk is still there.

ARMs give you a teaser rate. You need to do some serious homework and consult your loan officer as to the proper mortgage program for you. But if you're short term, a hybrid with a low teaser rate is the better choice.

One last note on ARMs and hybrids: When lenders evaluate your ability to pay the mortgage, they will look at your gross monthly income and the fully indexed rate with an ARM or 2 percent above the start rate for a hybrid.

For example, a lender will not use a 4.75 percent teaser rate to qualify you. Instead it uses the then-current index plus the margin. If the index is 5.00 percent and the margin is 2.75 percent, then the lender will use 7.75 percent as your qualifying rate.

 
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