Hybrid ARM | Housing | Finance & Capital Markets | Khan Academy

Hybrid ARM | Housing | Finance & Capital Markets | Khan Academy

In the last video, we covered the basics
of what an Adjustable Rate Mortgage is and how it's different from a Fixed Rate
Mortgage. But you may have heard another term that
seems to be a mixture of the two! And that is a Hybrid "ARM" or
Hybrid Adjustable Rate Mortgage. And a 'Hybrid', when we use the word
generally, means a mix of things. And that's exactly what a 'Hybrid ARM' is: It's a 'mix' of Fixed
(it's a mix, it's a mix) of Fixed & Adjustable, and an Adjustable
Rate Mortgage.

So what do we mean by "mix of a Fixed and
Adjustable Rate Mortgage"? Well, you might hear something like a, 5-1, a 5-1 Hybrid ARM. What does that mean? Well that means that the first 5 years of
a Mortgage, it behaves like a Fixed Mortgage, and then after that it
becomes Adjustable. So in the case that we used in the video
on Adjustable Rate Mortgages, we saw that as your benchmark one year
treasury rate fluctuates, that every year your Adjustable Rate Mortgage resets.
And if interest rates go high enough, it might become unfavorable relative
to the Fixed Rate. And this was just for the scenario that
we were looking at. Well, in the 5-1 Hybrid ARM, what happened
is that the first 5 years, it's a Fixed Rate Mortgage, and then after that it adjusts, it adjusts
as 1, 2, 3, 4, 5…

So the first 5 years, it's a Fixed Rate
Mortgage, and then after that it adjusts just like an Adjustable Rate.
And if it has the same properties as the Adjustable Rate that we saw in the video
on Adjustable Rate Mortgages, then we start adjusting. So that's for that year, and then the
year after that, maybe this year interest rates have gone down a little bit
so we pay a premium over the treasury…
So we start adjusting. So question is, why would someone want
to do this? One, why would a borrower want to do this?
And then, why does a bank do it? When we talked about Adjustable Rate
Mortgages, we talked about this idea of interest rate risk, that in an Adjustable Rate Mortgage, a
borrower takes on the interest rate risk. If interest rates go up, the borrower
will have to pay more interest but the lender is protected. On the other hand, for a Fixed Rate, if
interest rates go up, it's the lender who has to take on that
risk, while the borrower is protected.


While with a Hybrid, it's in-between. The
first 5 years, the borrower is protected. They know that "Hey look! I know what my
payment is going to be for those 5 years, and then after that, it adjusts." And that's also from a lender's point of
view. They're like, "Okay. We'll take on the interest rate risk for the first
5 years but then after that, because it is really hard to predict what interest
rates are going to be doing in 5 or 6 or 7 or 10 or 15 years, then it floats and the
borrower takes it on." It's not even the case that the borrower
initially even has to take on this risk. It could be the case that the borrower is
buying some type of a property, where they think that they will either sell the
property, or maybe they'll refinance the property.
But especially if they think they're going to
sell the property in the next 5 years,
this could make a lot of sense, especially if they get a lower rate than
they would've gotten with a Fixed Rate.

For example, the rate that they might've
gotten might've have looked something more like, it might've been a lower rate than
the Fixed Rate, very likely for the same credit risk,
it might've been a lower rate. And then after 5 years that's a lower rate
because the bank is taking on less of the interest rate risk especially when you go
out or when you go out beyond your 5. And then it would adjust. So the incentive is okay!
If I think I'm going to sell this house or refinance this house which means take another loan to pay this loan off,
if I think I'm going to be able to do either of those things in the
next 5 years, maybe it makes a lot
of sense for me to do this. So in a Hybrid, both parties are kind of
mixing – they're both taking different pieces of the interest rate risk and
once again, depending on your scenario, it might make sense to think about
something like a Hybrid ARM, if you feel very confident that you can either
take on the variable risk – the interest rate risk – that will happen after your 5,
or you think that this property is going to be something that you might own or …

that you'll only own for the next 5 years, or that you might refinance in some way,
or maybe you'll be able to pay it off, maybe you're expecting an inheritance
in your 4, and so you can just pay off the property or pay off the loan,
& you won't have to worry about all of this business right over

As found on YouTube

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