What Is a Hybrid ARM Loan?

For those seeking a home mortgage loan that offers a better low-interest rate than you can get with a fixed-rate mortgage (FRM), an adjustable-rate mortgage (ARM) might hold appeal. Although ARM loans offer lower rates than the fixed rate ones, they also come with some risks: Rates can rise as high as the prime rate does once the initial low-interest rate period of the loan has passed. But the hybrid ARM loan, a combination of a fixed rate and an adjustable rate loan, offers low interest at the beginning of the loan period and a cap (limit) on how high the adjustable interest rate can rise later in the loan.

Loan Details

A hybrid ARM's fixed-rate loan period is generally offered for a maximum of 3, 5, 7 or 10 years, with the lowest interest rate enjoyed by those who choose the 3- or 5-year option. After this time is up, the loan reverts to an adjusted rate (which runs the remainder of the mortgage loan time, 20 years or more) and could be as much as the prime interest rate at that time.

History of Hybrid ARMs

The hybrid ARM mortgage was introduced during the late 1980s, after other ARM mortgages had tried and failed. These other ARM loans offered low fixed-interest rates for a short time before reverting into an adjustable-rate loan (in which interest climbed higher and higher alongside the prime rate, with no cap on how high it could go). These loans were eventually tossed by consumers who chose to return to fixed-rate loans--at least until 18 percent fixed-interest rates started to occur.

The lending industry felt the hybrid ARM would be a good alternative to the high fixed-interest rate mortgages in the '80s, as well as the other ARM mortgages. The lending industry felt it could combine the best of both rates and produce a better lending product: a fixed rate and adjustable-rate mortgage combination--a hybrid ARM.

Benefit 1: Lower Interest Rate Going In

The reason people choose a hybrid adjustable-rate mortgage loan instead of a fixed-interest mortgage loan is generally due to several significant benefits you get with this kind of loan. One of those benefits is a lower interest rate. Initially, and for 3, 5, 7 or 10 years after (depending on the length of the fixed-rate portion of the loan chosen), the borrower would enjoy a lower interest rate than fixed-rate borrowers.

Benefit 2: Low Rate for an Extended Time

The second benefit was that the loan's low interest rate--known by some as a teaser rate--was a fixed rate for a set period (3, 5, 7 or 10 years), depending upon the option chosen when taking the loan. If you wanted the lowest interest rate possible, you chose the 3-year option; if you wanted a lower rate than the fixed-rate loans offered but were also concerned about possible interest hikes that might occur when your loan reached the adjustable-rate portion of the loan, you could choose the 10-year option.

Benefit 3: Flexibility to End the Loan

The third benefit is the ability to enjoy all of the loan's strengths--lower monthly mortgage payments, lower interest paid during the loan period and greater property equity--yet also avoid the possible rising interest rate. Some choose to take out the loan and then terminate it (by refinancing when it reached the higher adjustable interest), generally after 3, 5, 7 or 10 years.

Drawbacks

Some people take out this type of loan with the idea that they'll enjoy its perks (low interest rate, low monthly payments and faster equity building) and then refinance when this loan reverts to the higher-interest, adjustable-rate arm of the loan. They do this especially if they're unprepared financially for the higher interest rate and higher monthly payments they might experience.

But if the lending market isn't extending credit at the time the loan enters the first year of the adjustable interest rate (as has been the case in some places), or if the homeowner has lost his job and couldn't get approved for a loan to refinance, he might not be able to manage the higher interest and monthly payments.