ARM, Hybrid or Fixed-Rate Loan?

By Dr. Don Taylor, Ph.D., CFA, CFPBankrate.com

Dear Dr. Don,

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I would like to know the pros and cons regarding adjustable-rate mortgages. I was told they are locked in for five years. Is this correct?

-- Bonnie Binding

Dear Bonnie,

An adjustable-rate mortgage, or ARM, can be structured in many different ways. The interest rate on an ARM is based on a pricing spread to an underlying interest rate. There can be an initial "teaser" rate, or a floor or minimum rate, a cap or maximum rate and limits on how much the interest rate can change on a reset date. The Bankrate feature on understanding adjustable-rate mortgages provides a nice primer on these issues.

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An ARM that has its interest rate locked in for a multiyear period, such as a 5/1 ARM, is a hybrid mortgage product. The interest rate is fixed for five years and then resets every year, based on the parameters discussed. There are several different fixed-rate terms for a hybrid ARM, including 3/1, 5/1, 7/1 and 10/1. Bankrate reports the national average for a 5/1 ARM every Thursday in its Mortgage Analysis. You may also consider "interest-only" hybrid ARMs, where the borrower in the early years of the loan only pays the monthly interest expense on the loan amount.

ARMs typically have lower interest rates than fixed-rate mortgages because the lender is shifting the risk of higher interest rates over to the borrower. The interest rates on hybrid ARMs generally fall between the rates on fixed-rate mortgages and those on typical ARMs because the lender now faces the interest-rate risk for a set number of years.

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