The Hybrid Adjustable Rate Mortgage: Four Key Questions to Ask

Despite all the bad news you may have heard about the financial trouble people got themselves into with unique mortgage products such as payment-option and interest-only adjustable rate mortgages, conventional Hybrid ARMs remain a legitimate consideration for many homebuyers. Hybrid ARMs have been around for more than three decades and still can make sense today for people who don't plan to stay in their homes for more than the initial low-rate period of the loan. Of course, understanding how the interest rate is adjusted and how this change will affect your monthly payments is critical to being properly prepared. Below are four questions to ask if you are considering Hybrid ARM as an alternative to a fixed-rate mortgage.

How Long Does the Fixed-Rate Period Last?

Hybrid ARMs feature fixed-rate periods at the beginning of the loan, followed by interest rates which most commonly change once per year thereafter. A 5/1 Hybrid ARM will have a fixed interest rate period of five years, after which the interest rate will start to change every year. A 7/1 Hybrid ARM would have a mortgage rate for the first seven years and then annual adjustments, and so on.

However, many newer Hybrid ARMs have six-month or even three-month adjustment periods after the fixed-rate period concludes, so you'll want to ask the lender and read the documents carefully to make sure you know how yours will work in the future.

The Adjustable Mortgage Rate Portion: What Index is Used?

When the rate is due to change, it will be adjusted according to the value of a specific economic indicator, such as the yield on a given Treasury Security, the Secured Overnight Financing Rate (SOFR) or even contrived indexes like the MTA/12-MAT or Federal Cost of Funds. Even in the same market conditions, any given index can move very differently from another, so find out which index is used to govern the loan.

What is the Mortgage Lender's Margin?

On top of the value of the index, mortgage lenders tack on a markup, called a margin. Find out the margin amount on the ARM. While lenders don't have any direct control over the value of the index, they can have influence on the margin, so it pays to shop around. The index plus margin equals the mortgage rate you'll pay, subject to any interest rate limitations, called caps.

What are the Mortgage Interest Rate Caps?

There are three types of caps to consider with a Hybrid ARM: a cap on how much the interest rate can move in the first adjustment (the "initial" cap), a cap on how much the interest can move in each of the other adjustments (the "periodic cap"), and a cap on how high the interest rate can ever move, relative to where you started (the "life cap"). It's a good idea to find out all three and do some calculations on what your mortgage payments would be if the interest rate adjustments rise enough to hit the caps. Typically, the caps on Hybrid ARMs are 5 or 6 percentage points for the initial cap, 1 or 2 percentage points for the periodic cap and 5 or 6 percentage points for the life cap. As such, the change at the first adjustment can be rather pronounced.

It's also worth noting that interest rate caps work in both directions; that is, they can help prevent or forestall interest rate and monthly payment increases in a rising interest rate environment, but can also hinder lower rates and payments from reaching your wallet should market-based interest rates be trending lower.

Is a hybrid ARM a good substitute for a fixed-rate mortgage?

A hybrid ARM can be a good potential substitute for a fixed rate mortgage, but this statement comes with plenty of caveats. It's important to know that selecting a hybrid ARM isn't a risk-free choice, since interest rates and your mortgage payment can rise in the future. Whether the choice of a hybrid ARM works out to your advantage or not will depend on how long you end up holding on to it, what happens to interest rates during the fixed-rate period and beyond, and your ability to manage potentially higher future monthly payments.

As you mull mortgage possibilities, check today's mortgage rates. There's also a lot more to know, so you'll want to read "Should I consider an ARM?" as you look to choose the mortgage that's right for you.

For an in-depth look at ARMs, see HSH's comprehensive guide to adjustable rate mortgages