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Don't Be Afraid Of Hybrid ARMs

These types of adjustable-rate mortgages can save you a substantial amount of money compared with conventional fixed-rate mortgages.

Some adjustable-rate mortgages may have been lumped in with such “toxic” mortgage products as interest-only loans, pay-option ARMs and loans with negative amortization, but those are not the same as more conventional products known as hybrid ARMs. These are loans that carry fixed rates for the first five or seven years, after which the rate is adjusted up or down annually based on market conditions at the time.

Hybrids are “a great product at a great rate,” said Silver Spring, Md., mortgage broker Christopher Cruise, who has several clients ready to lock in a starting rate of 3.99%.

That’s a full percentage point or more lower than what the traditional 30-year fixed-rate mortgage is going for these days. And the savings over five or seven years can be substantial. But many people are scared of hybrids because they are lumped in the same “bad loan” category as more treacherous adjustables.

Hybrids aren’t for everyone. But they’re not nearly as risky as other ARMs that come with below-market “teaser” rates that make them even more enticing — and more dangerous.

Here’s a quick primer about the differences.

With an interest-only loan, you pay just the interest for a few years. After that, your payment increases dramatically, not only because you are amortizing the principal over a shorter time frame (typically 30 years less the interest-only period) but also because your rate jumps up to market level.

Pay-option ARMs also work just as the name implies. You can make practically any kind of payment you like. You can elect to make a full payment. You can choose to pay only the interest. Or you can even make a partial payment to principal.

Most people take the easy way by paying only the interest. And again, when the option period expires, the payment jumps significantly because the principal is amortized over the remaining term and the rate increases to market level.

These loans are even more dangerous if they come with negative amortization. If your payment isn’t enough to cover the interest due because of annual increases in the rate, the difference is added to the principal. And that means you could end up owing more than what you originally borrowed.

Then there are the hybrids, which have a significantly longer period of fixed rates and come with annual and life-of-loan caps that protect borrowers against payment shock. A typical annual cap is 2 percentage points, meaning the rate can go up no more than that, while a typical lifetime maximum is 6 points.

Cruise, the Maryland broker, believes that people who dismiss hybrids out of hand in favor of more conventional 30-year fixed-rate loans are “stuck in the 1950s,” an era when many people bought one home and lived in it forever.

One key to picking a loan these days is how long you plan to remain in the home. Another is how long you will keep the loan. Although people will probably be staying put longer because of the recession, they are turning in their old loans for new ones faster than ever.

The mistake most borrowers make, Cruise said, is that “they look at the possibility” that they’ll have the same house and loan five or seven years from now “instead of the probability.”

“Even if they stay in the same house,” he said, “seven years for a mortgage is an eternity these days.”

Keith Gumbinger of HSH Associates, a mortgage-information company based in Pompton Plains, N.J., isn’t as gung-ho about hybrids as Cruise. But he does agree that they shouldn’t be dismissed out of hand. “There might be an opportunity there,” he said. “Certainly in the jumbo market, you have to take a look.”

That “look” might involve some work. “You’ll have to go out and scour the market to find a very good deal,” said Gumbinger, whose firm surveys lenders every week.

Let’s see how a 7/1 ARM plays out over time for a $250,000 mortgage, using a 1 percentage point difference between a 30-year fixed-rate loan at 5% and the adjustable loan at 4%. The difference between the monthly payments to principal and interest for the two mortgages is $148 — $1,194 for the ARM versus $1,342 for the fixed-rate mortgage. Over a year’s time, the savings is $1,776. And over the seven-year period the savings is $12,432.

The next question is, how long will it take to give back that money once the loan switches to a one-year adjustable? Let’s consider a worst-case scenario: Say on the loan’s eighth anniversary, the rate jumps the maximum allowable 2 percentage points, to 6%. That means the payment will rise to $1,499. That’s a bump of $305 a month.

Over a year’s time, that’s $3,660 extra out of your pocket. But you’re still ahead by $8,772 ($12,432 less $3,660).

Now say that in the ninth year, the rate jumps again by the 2-point maximum, to 8%. In that case, your payment this year will leap by $335, to $1,834, and your annual cost over and above your original payment will be $7,680. But again, you’re still ahead, albeit by this time the savings is just $1,092 ($12,432 less $7,680 less $3,660).

It’s not until early in the 10th year that you start giving back what you saved over the first nine years.

Of course, this ARM could become even more burdensome if the rate jumps again by 2 more points after 10 years, to 10%, or double what you would still be paying if you had decided to go with a fixed rate.

But with the life-of-loan cap, that’s the highest it will ever go. And who knows? Market rates could go down, which means your payment could go down.

Now let’s consider a jumbo mortgage. The differential isn’t as great in the jumbo sector — 6.5% for a fixed loan, according to HSH, versus 5.9% for a 7/1 ARM. But because the loan amounts are so large, the dollar differences are larger.

At 6.5%, a $750,000 fixed-rate mortgage costs $4,741 a month for just principal and interest. But at 5.9%, the ARM runs $4,449, a savings of $292 a month and $3,504 a year. Over the seven-year period, the total savings is $24,528.

Assuming the worst case from here on out, the payment on this fictitious $750,000 loan could jump 2 percentage points in year eight, to $5,541, an increase of $1,002 a month and $12,024 for the year. But you are still ahead, this time by $12,504.

It’s only if the rate goes up by 2 more points in year nine that you end up in negative territory. It’s then that the payment rises to $6,526. That’s $2,077 more than what you started out paying with the ARM.

But you are still ahead of the game until the sixth month of the ninth year with a 7/1 ARM.