A 5/6 hybrid adjustable-rate mortgage (ARM) offers an appealing combination for many homebuyers: a fixed interest rate for the initial five years, followed by an adjustable rate every six months. This type of ARM merges features of both traditional fixed-rate mortgages and adjustable-rate mortgages to provide initial stability with the potential for future flexibility.
Key Benefits and Challenges
- Stable Start: A 5/6 hybrid ARM provides a five-year fixed interest rate, giving you predictable monthly payments during this period.
- Rate Adjustments: After the first five years, the interest rate adjusts semi-annually. This rate is typically based on a benchmark index, which can offer both risks and advantages depending on market trends.
- Potential Savings: Initially, the interest rates are usually lower compared to long-term fixed-rate mortgages, potentially leading to significant savings if you plan to sell the home or refinance within five years.
- Interest Rate Cap: Many 5/6 hybrid ARMs include caps that limit how high the interest rate can rise over the life of the loan, offering some protection against substantial rate hikes.
How a 5/6 Hybrid ARM Operates
Initially, a 5/6 hybrid ARM has a fixed interest rate for the first five years. After this period, the interest rate adjusts every six months, usually tied to a common benchmark index such as the prime rate. The interest rate you pay will be the benchmark rate plus a margin set by the lender. For example, if the current benchmark rate is 4% and the margin is 3%, your fully indexed interest rate will be 7%.
Indexing and Rate Adjustments
Lenders employ various indexes to set interest rates on 5/6 hybrid ARMs. Common choices include the U.S. prime rate and the Constant Maturity Treasury (CMT) rate. The frequency of rate adjustments can influence your payment stability: in a rising rate environment, less frequent adjustments are better, while in a falling rate environment, more frequent adjustments are advantageous.
Comparing 5/6 Hybrid ARMs to Fixed-Rate Mortgages
Advantages of a 5/6 Hybrid ARM
Many adjustable-rate mortgages, including the 5/6 hybrid ARM, start with lower interest rates compared to fixed-rate mortgages. This can provide substantial immediate savings, especially if you intend to sell the property or refinance before the fixed-rate period ends. However, confirm that your lender doesn’t impose costly prepayment penalties.
Disadvantages of a 5/6 Hybrid ARM
The primary risk of a 5/6 hybrid ARM lies in periodic interest rate adjustments. With the potential for rate increases every six months after the initial fixed period, monthly payments may become unaffordable. While many ARMs have caps to regulate how much rates can rise at any given time and overall during the loan term, fixed-rate mortgages do not carry this risk as their interest rates remain constant.
What You Should Know About Adjustable Rate Mortgages
An adjustable-rate mortgage (ARM) features an initial period of a fixed interest rate, after which the rate resets periodically based on a specified index. The initial rate typically reflects the borrower’s creditworthiness and the prevailing market rates. After the fixed-rate period, the adjustable rate is calculated by adding the lender’s margin to the benchmark index.
Interest Rate Caps: A Protective Measure
To protect borrowers, many 5/6 hybrid ARMs have caps in place, which restrict how much the interest rate can climb in any adjustment period and throughout the life of the loan. Be sure to understand these caps as they could significantly impact your future payments.
Conclusion
A 5/6 hybrid adjustable-rate mortgage offers the predictability of a fixed-rate mortgage for the first five years and the flexibility of an adjustable-rate mortgage thereafter. While it can lead to immediate savings, potential interest rate hikes pose a risk. Therefore, understanding the structure and terms of ARMs, including interest rate caps and adjustment frequencies, is essential to making an informed decision.
Related Terms: fixed-rate mortgage, prime rate, margin, interest rate risk, refinancing, creditworthiness
References
- Consumer Financial Protection Bureau. “Consumer Handbook on Adjustable-Rate Mortgages”, Page 4.
