The hybrid ARMS - those are the loans that fix the interest
rates for an initial period of time and then turn into adjustable
rate loans for the remainder of the term - have been versatile
loan products to help clients save money.
When I discuss loan programs with clients, I usually will
give them an idea of their choices by showing them a
spectrum of typical mortgage products.
These include the following:
30-year fixed rate loan - most stable, highest rate
15-year fixed rate loan - retires loan quicker, higher payments
10-year hybrid ARM - targeted to cover a period of ownership
7-year hybrid ARM - targeted to cover a period of ownership
5-year hybrid ARM - targeted to cover a period of ownership
3-year hybrid ARM - targeted to cover a period of ownership
1 year adjustable rate loan - useful for short-term strategies
Semi-annual adjustable rate loan - useful for short-term strategies
Monthly adjustable rate loan - lowest payments, allows for
negative amortization
Some clients will prefer the 30-year fixed rate loan because they
will be guaranteed that there will be no surprises in that loan. If
they can afford the payments today, they should be able to
continue to afford the payments in the future.
The 15-year fixed rate loan has appeal to those clients who want
to have their loan paid in full, usually to coincide with a retirement
strategy. The interest rate on the 15-year loan is generally a little
less than the rate offered on a 30-year loan.
The 1-year and semi-annual adjustable rate loans are usually of
interest to borrowers who have a very short term strategy in owning
the home. They enjoy the benefit of the lower interest rate that
the adjustable rate loan offers initially, and plan to dispose of the
property before the loan has an opportunity to adjust to any large
degree. Because these loans offer interest rate caps per adjustment
period, they can forecast what their worst-case scenario would be in
the near future.
The monthly adjustable rate loan is also known as the deferred
interest option loan, or the negative amortization loan. This program
allows a borrower to make a minimum payment that is actually less
than the interest owing at the time. If the borrower pays the
minimum payment, the unpaid interest gets added to the principal
balance of the loan and the loan gets larger each month. This loan
can be the right mortgage vehicle in certain circumstances, but
the client deserves to fully understand how this loan works so that
there are no surprises. In a future issue, I will feature this loan.
The 10-year, 7-year, 5-year and 3-year hybrid ARM loans serve a
very useful purpose for a majority of borrowers. The longer that a
lender is asked to guarantee an interest rate, the rate is usually
higher. So, a 30-year loan carries a higher interest rate than a
15-year loan, which in turn is higher than the 10-year hybrid
ARM, the 7-year hybrid ARM, the 5-year hybrid ARM, and the
3-year hybrid ARM.
The key to a suitable recommendation for a client is to determine
how long they intend to own the home. If they intend to own the
home for 5 years, it would not be wise to recommend the 3-year
hybrid ARM, because they would face an adjustment to the
interest rate before they planned on moving. In this case the 5-year,
7-year, or 10-year hybrid ARMS would be worthy of consideration
to protect the borrower with a guaranteed interest rate for the
period of time they intend to own the home, and to give them
additional protection in the event that their time frame slipped
from their initial plan.
The hybrids function like this:
The term of the loan is typically 30 years, with the initial interest
rate guaranteed for a specified period of time - 10, 7, 5 or 3 years.
When the loan reaches the end of that guaranteed period of time -
let's use the 5 -year as our example - the loan ceases its fixed rate
period and turns into an annual adjustable rate loan. So, beginning
after the 60th month, the new interest rate is calculated by using an
index that is specified in the loan documents and determining the
index value at that point in time, and adding to it a "margin" that is
also specified in the loan documents that can best be thought of
as the lender's profit margin.
Many of these loans use the 1-year LIBOR index and have a margin
of say, 2.75%. Using today's rates as an example, a borrower could
expect their new interest rate to be 4.893% for the LIBOR value plus
2.75% margin, giving the borrower a new rate of 7.643% for the next
year. The payments would be calculated on the remaining balance
at the end of the 5 years over a 25-year period (the remaining term
of the loan) at an interest rate of 7.643%.
At the end of that year, the lender would do a new calculation using
the same formula but setting the payments over a 24-year period.
There are additional features of these loans to be considered. Many
programs will allow for interest-only payments which allows the
borrower to make the lowest possible payment and it keeps their
principal balance on the loan level. Many lenders will also allow
for slightly lower interest rates or fees if the borrower will accept a
prepayment fee for the first year or 3 years.
Since these loans have been introduced, many borrowers have
chosen them as their preferred mortgage product. As always,
make sure that the details and the answers to your "What if..."
questions are fully explained to you so that you can make an
informed decision.
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