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Brian French

The Hybrid ARM - Not Manmade Evil!

Monday, August 26, 2013 - Article by: Brian French - Top Flite Financial, Inc - Message

The heady days of the housing market boom in the latter 90's on through the middle 00's represented hedonism at its best. The rapid over-expansion of the nascent technology marketplace created a surge in cash that desired a high rate of return and wealth that generated a confidence to spend. One of the target sectors for this cash was real estate. The rapid influx of money led to a boom in housing construction, an increase in cash-out refinances, and the spawning of a new segment - "flipping". Real estate and financial professionals began companies focused on purchasing older homes and houses in disrepair, renovating and refurbishing them, and then selling them for huge profits. Life was good.Banks across the country witnessed the rapid growth in this marketplace and yearned to obtain their piece of the pie. As competition heated up in the mortgage lending market, banks designed new, creative loan packages to lure investors to utilize their services. Investors with significant wealth and cash were able to obtain financing in short order. In order to expand the demand for the new and refurbished houses and to ensure "equality", the government pressured lenders and government-sponsored agencies like Freddie and Fannie to loosen their underwriting guidelines so all Americans would have a greater opportunity to attain home ownership status. Even more "creative" mortgage products were thus created for the next wave of borrowers, which included the novice "home-flippers". The ARM (adjustable rate mortgage) and many new variations of this known product became popular vehicles for normal residential purchases and home-flippers across the country. The rising tide was indeed lifting all boats, though the tsunami lurking out at sea went virtually unnoticed.As is the case with any market surge, the expected demand increases from year to year are grossly overestimated by the marketplace in the feeding frenzy for profits and market share. In addition, many of the ARM products that were utilized to finance the demand contained short-term interest-only or, even less than interest-only, features that began to reach maturity. At maturity, many of them would reset to fully-amortized loans with higher fixed rates of interest. Thus, as supply exceeded demand and monthly payments reset to much higher levels, the storm reached its peak and the housing market crashed. You know the rest of the story.As the storm receded and the blame game began, the ARM hit the 10 Most Wanted List and its vilification began. It became one of the scapegoats for the crisis and the result was the unfortunate besmirching of its reputation. Often times in my consultations with clients, the ARM appears to be a logical option for his/her financing needs. However, more than 9.9999999 times out of 10, the customer immediately rejects the option, declaring that he/she would never use an ARM, often remarking that it was what got us into the mess we are in. With interest rates rising, I suspect that it will become more attractive and it is important to understand the new product and its proper application.The hybrid arm is a financial tool to be used in situations where the needed term is clearly defined. There are many variations on the theme, but the concept is that it sets the rate for a specified period of time with a 30-year amortization. After the fixed-rate period of time, the rate can change based on a defined interest rate index (LIBOR, etc), cycle, and cap. For example, a hybrid arm would be an excellent fit for those whose careers find them moving on a set cycle. I have a friend whose job requires him to change positions and locations every 3 years as a means of training him for an executive position. As such, utilizing a 5/1 ARM (an extra 2 years to ensure fixed-rate security) allows him to enjoy a rate lower than a 30-year fixed rate with the benefit of a 30-year amortization - a combination that affords him a low monthly payment. On the other hand, utilizing the hybrid ARM to purchase a home more expensive than a client would be able to afford utilizing a 30-year fixed rate loan is not the intended use of this product and could lead to payment shock when the ARM resets. The latter was one of the causes of the housing crisis from which we are now just starting to emerge. ARMS of all types should have their rightful place in our financial quivers. They are excellent financial vehicles for specific types of transactions and clients. If used correctly, they allow the client to purchase a property with lower interest expense and a lower monthly payment overall, maximizing their principal contribution and monthly cash flow.

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