Once upon a time in the mid-1990s — 1994 to be precise — 30-year fixed mortgage rates were hovering in the high single digits and threatening to break the 10% threshold. Some smart guy in some small bank somewhere had an idea for a better mousetrap and the Hybrid ARM was born. Part fixed, part adjustable with an initial “teaser” rate far below 30-year fixed rates, the Hybrid ARMs quickly became the mortgage financing product du jour.
Let’s review the mechanics:
Hybrid ARMs as the name implies, have a fixed rate component on the front end of the mortgage term (3 years, 5, 7 or 10) and anadjustable rate component on the back end of the mortgage term, when the interest rate can change/adjust annually. For example; a 5/1 ARM in today’s market could have an interest rate that is fixed for the first 5 years at 3.00% compared to a 30-year fixed rate mortgage at 4.50%. For a $200,000 mortgage, that would save $170/month. After 5 years/60 months, the interest will adjust annually based on an index (1 year LIBOR or 1 year Treasury/CMT), plus a margin of somewhere between 2.25% and 2.75%.
Of course there are caps on the interest rate adjustments. Typically the initial adjustment cap is 2% above the start rate, unless the initial term is 5 years or longer, then the initial caps can be as high as 5%. The periodic or yearly caps are typically 2% above (or below) the existing rate and the lifetime cap is 5% or 6% above the initial fixed rate, depending on the term.
Since birth, hybrid ARMs have maintained space on the entrée side of the menu, for a time even expanding to include interest only variations, which have become scarce now that QM is sheriff. While fixed rates have enjoyed a prolonged period of historical lows, the demand for hybrid ARMs has fallen dramatically.
Enter the current generation of mortgage consumers with a seemingly much lower tolerance for rising interest rate pain than their counterparts of 20 years ago, and demand for hybrid ARMs is seeing traction. Technology has given buyers access to more information than ever before, comparing options for individual circumstances results in savvy mortgage consumer financing choices.
The buyer with a five year planning horizon choosing the $200,000 5/1 ARM over the 30-year fixed mentioned earlier, would save $10,200 and enjoy the security of a fixed rate for those five years. If plans change as they so often do (when life shows up), the adjustment caps can protect those savings while plans are adjusted and new mortgage financing strategies are considered. This is the nature of today’s generation of mortgage consumer; they are sophisticated, they have access to more information for more informed consideration and they want what best fits their personal financial universe.
At some point in the future, mortgage interest rates will begin the inevitable climb to higher norms and Hybrid ARMs will have a louder voice in the mortgage financing conversation. As with virtually everything else, organic evolution has led to 3/3 ARMs and 5/5 ARMs and other variations that together offer consumers a menu of custom made mortgage financing options for just about every circumstance. Learning the mechanics of how these loans work and matching planning horizons with adjustment periods can be a useful tool in an overall financial planning portfolio.