A hybrid ARM is a type of adjustable rate mortgage. This is one in which the interest rate charged on the loan can vary, often based on rates set by a central bank. A hybrid ARM has a fixed rate for a set time and then reverts to an adjustable rate. If the adjustable rate is considerably higher at this point, it can cause financial problems for the borrower known colloquially as mortgage shock.
As a general principle, mortgages work on one of two systems. A fixed-rate mortgage is like most non-property loans in that the interest rate is agreed in advance and applies throughout the duration of the loan. This in turn means the repayment amounts can be fixed for the entire loan.
An adjustable rate mortgage, or ARM, allows the lender to vary the rate. In theory they could do this at will, but in most cases it is linked to other variables. For example, it may be linked to the cost which the lending bank itself must pay to borrow money from other banks. In most economies, this will ultimately derive from the base rate set by a central bank, which may or may not be directly government controlled. These links may be loose and informal, acting simply as an influence on the mortgage rate, or they may be fixed so that a move in the base rate has a direct and proportional effect on the mortgage rate; this is often known as a tracker mortgage.
Generally lenders prefer to offer an adjustable rate when it comes to mortgages. This is mainly to better protect themselves against changes in the cost of borrowing the money which funds mortgages, and the effects of changes in inflation. One drawback of this is that when adjustable rates are relatively high, it can be harder to attract new borrowers.
The hybrid ARM is one solution to this. It is a mix of the two systems and means that the mortgage rate is initially fixed for a set period, most commonly one, two or three years. This can be attractive to borrowers, particularly first-time buyers, as it offers them some stability and predictability, making it easier to budget. In many cases a hybrid ARM will have a low rate for the fixed rate period as a way to attract customers.
At the end of the fixed rate period, a point known as the reset date, the hybrid ARM returns to the prevailing adjustable rate. In many cases this rate will be higher than before. If the rise is higher than expected; for example, if base rates have risen sharply since the mortgage began, the lender may have trouble affording the new repayment amounts. One option in this case is to attempt to find another bank and remortgage the property, using the proceeds to pay off the original mortgage and taking advantage of a lower initial rate on the new mortgage. This tactic can be limited by the costs associated with taking out a mortgage, and any changes to the competitiveness of the mortgage market that may have occurred.