5-6 Hybrid Adjustable-Rate Mortgage - 5-6 Hybrid ARM
What is '5-6 Hybrid Adjustable-Rate Mortgage - 5-6 Hybrid ARM'
5-6 Hybrid Adjustable-Rate Mortgage (5-6 Hybrid ARM) is an adjustable-rate mortgage with an initial five-year fixed interest rate after which the interest rate begins to adjust every six months according to an index plus a margin, known as the fully indexed interest rate. The index is variable, while the margin is fixed for the life of the loan.
5-6 ARMs are usually tied to the six-month London Interbank Offered Rate (LIBOR) index, the world’s most widely-used benchmark for short-term interest rates. Other popular indexes for indexed rates include the prime rate and Constant Maturity Treasury indexes.
BREAKING DOWN '5-6 Hybrid Adjustable-Rate Mortgage - 5-6 Hybrid ARM'
5-6 Hybrid Adjustable-Rate Mortgage loans have multiple features to consider. When shopping for an ARM, the index, the margin and the interest rate cap structure should not be overlooked. The margin is a fixed percentage rate that is added to an indexed rate to determine the fully indexed interest rate of an adjustable rate mortgage. The cap structure refers to the provisions governing interest rate increases and limits on a variable rate credit product. In a rising interest rate environment, the longer the time period between interest rate reset dates, the more beneficial it will be for the borrower. For example, a 5-1 ARM would be better than a 5-6 ARM. The opposite would be true in a falling interest rate environment.
Additionally, most indexes behave differently depending upon the interest rate environment. Those with a built-in lag effect, such as the Monthly Treasury Average (MTA) Index, are more beneficial in a rising interest rate environment than short-term interest rate indexes, such as the one-month LIBOR. The interest rate cap structure determines how quickly and to what extent the interest rate can adjust over the life of the mortgage. Finally, the margin is fixed for the life of the loan, but it can frequently be negotiated with the lender before signing mortgage documents.
Pros and Cons of a 5/6 ARM
Pros: Many adjustable rate mortgages start with lower interest rates than fixed-rate mortgages. This could provide the borrower with a significant savings advantage, depending on the direction of interest rates after the initial fixed period of an ARM. It might also make more sense from a cost perspective to take an ARM, especially if a borrower intends to sell the home before the fixed rate period of the ARM ends. Historically, people spend seven to 10 years in a home, so a 30-year fixed-rate mortgage may not be the best choice for many home buyers. Let’s use the example of a newly married couple purchasing their first home. They know from the outset that the house will be too small once they have children. Therefore, they take out a 5/6 ARM, knowing they’ll get all the advantages of the lower interest rate because they intend to buy a larger home before or near the time the initial rate is subject to adjustment.
Cons: The biggest risk associated with a 5/6 ARM is interest rate risk. It could increase every six months after the first five years of the loan, which would significantly raise the cost of monthly mortgage payments. Therefore, a borrower should estimate the maximum potential monthly payment they could afford beyond the initial five-year period. Or, the borrower should be willing to sell or refinance the home once the fixed period of the mortgage has ended. The interest rate risk is mitigated to a degree by lifetime and period caps on 5-6 ARMs. Lifetime caps limit the maximum amount an interest rate can increase beyond the initial rate, while periodic caps restrict how much the interest rate can increase during each adjustment period of a loan.