What is a hybrid mortgage? Is it right for you?
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The fixed-rate mortgage and the adjustable-rate mortgage are two popular home loan products. A fixed-rate mortgage has a fixed interest rate for the entire life of the loan. An adjustable-rate mortgage (ARM) usually starts off with a lower interest rate and payment than a fixed-rate mortgage, but the trade-off is interest can increase during the loan term.
If you’re looking for a product that gives you the best of both worlds — you’re in luck. The hybrid mortgage has features of both home loan types.
What is a hybrid mortgage?
A hybrid mortgage is a type of ARM that offers a fixed rate for a predetermined period and then an adjustable rate for the rest of the loan term. Usually, the fixed interest rate is given to borrowers on the front end for up to 10 years. Afterward, the interest rate becomes adjustable like a standard ARM. The interest rate during the ARM can adjust monthly, quarterly, annually or every few years.
Mortgage adjustments are calculated using an index. Lenders tack on an additional margin percentage to the index to calculate your mortgage interest rate. An index, such as the LIBOR, is essentially a benchmark that’s used as a reference point. Index rates can change as a result of economic conditions. Rates may trend upward in times of economic prosperity to protect against inflation. On the other hand, a decrease in index rates can take place to stimulate the market during an economic downturn.
How does a hybrid mortgage work?
You’ll often see hybrid mortgages expressed like this — 3/1, 5/1, 7/1, or 10/1.
The number before the forward slash (3, 5, 7, or 10) is the number of years interest is fixed. The second number usually tells you how often the interest rate will adjust after the fixed interest period ends. The 1 in the second position means your rate will adjust once every year. There may be some variation in how hybrid mortgages are expressed so you should always discuss the terms with lenders when shopping for a loan.
An adjustable interest rate comes with a level of risk. There’s no way to predict with absolute certainty what may happen to your rate during the adjustable-rate period – it could go up, it could go down. However, checking the index your lender uses and paying attention to economic conditions could help you make educated guesses as to how your rate will move.
The interest rate and payment caps
Interest rates and payments adjust, but they can only adjust so much because of caps. There are multiple-rate cap conditions that could be included in hybrid mortgage terms.
Hybrid mortgages can have an initial adjustment cap that limits how much your rate can adjust the very first time after the fixed-rate period ends. There can also be a cap in place to limit the rate hikes for each adjustment period. Two percent is a typical percentage cap that can’t be exceeded from one adjustment period to another. A lifetime rate cap may also be in place to limit how many percentage points your rate can increase overall.
Monthly payments can have restrictions as well. You may be relieved to hear that the lender is capping how much you pay per month, but this can actually cause you some trouble. The loan can go into negative amortization if your payment isn’t enough to cover the interest due on the loan. In this scenario, you could end up owing more than your initial loan amount. The conditions for negative amortization are another factor you must discuss with your lender.
What’s the appeal of the hybrid mortgage?
Hybrid mortgages and other ARMs usually have a lower starting introductory interest rate than the standard 30-year, fixed-rate mortgage. Lenders take on the risk when offering a fixed rate for such a long loan term and so you’re charged a bit for peace of mind. The initial savings from a hybrid mortgage can make it seem like a no-brainer opportunity, but the competitive interest rate and payments may not last forever. If interest rates go up, your payment will follow. There’s always a chance your rate could float down, but it’s a gamble.
For some homebuyers, it’s better to forgo the upfront savings and stick with the long-term fixed-rate mortgage because of the certainty it can provide. In other cases, the lower starting monthly payment for the first three, five, or ten years can be used strategically. We’ll discuss scenarios where a hybrid mortgage can make sense for you below. But first, if you’re considering a hybrid mortgage, you need to be aware of details that will help you determine potential costs.
Here are a few questions you should ask your lender:
- How long will the fixed-rate period last?
- What index is used to calculate the interest rate?
- What’s the margin you add onto the index rate?
- How often will my rate adjust after the fixed-term ends?
- What’s the rate cap per each adjustment?
- What’s the rate cap for the life of the loan?
- Is there a payment cap? If so, what is it and how will negative amortization be handled?
The advantages of a hybrid mortgage
The long, fixed-rate period. A hybrid mortgage can give you a fixed introductory interest rate that lasts for a decent amount of time. The fixed-rate coupled with the ARM later in the mortgage gives you the benefits of both mortgage types.
Possibly lower starting payments. Hybrid mortgages generally have a lower starting interest at the beginning of the mortgage compared with other fixed-rate mortgage products. A lower interest rate can offer you a lower mortgage payment, leading to upfront savings. Savings from the introductory period can be put to use elsewhere in the new home, i.e. furnishing, improvements or decor. It’s possible rates will trend downward, which can also lead to long-term savings.
Rate caps. Rates can increase after the fixed period but they can’t increase uncontrollably. Hybrid mortgages have rate caps in place so there are some guidelines for the amount that your rate can change.
The disadvantages of a hybrid mortgage
The risk and uncertainty after the fixed period. Yes — there are rate caps, but that doesn’t take away from the fact that you could be paying more later. You may not know what your payments will be five, ten or fifteen years from now. If you’re risk-averse — tread lightly. You can pay attention to economic trends so you’re not completely in the dark about your rate. But you can’t predict exactly what your interest rate will be later on.
Payment caps. Negative amortization because of a payment cap can deal a huge financial blow. Discuss with your lender what rate caps and payment caps can mean for your loan.
Is a hybrid mortgage right for you?
Ultimately, borrowers must go into a hybrid mortgage, or any other ARM product, knowing that the interest rate at some point will fluctuate. There are certain situations where this product can be a good move and other cases where you should skip right over it and stick with a fixed-rate mortgage.
The low starting payment for a hybrid mortgage can be attractive to buyers in situations where a small payment upfront is worth the risk of having a larger payment later. For example, a buyer may intend to sell the home quickly anyway so they’ll avoid the ARM period altogether. Maybe you only plan to stay in a location for a short time, or you’re flipping an investment property. In these situations, a hybrid mortgage could benefit you. Although, you should have a deep understanding of the local housing market if you’re banking on a sale. Otherwise, you could have a house you don’t want with a high payment sitting on your hands.
There are also instances where people who plan to stay in a home for the long haul can benefit from a hybrid mortgage. If you’re expecting to land a high-paying job, or you’ll be receiving a cash windfall before the fixed-rate period term ends, you may be able to comfortably afford higher payments when the rate adjusts. However, another warning here is necessary. You should be keenly aware of what the economic conditions are to know what you’re getting yourself into. Incremental fed funds rate increases are projected over the next year, which is sure to impact mortgage rates. Learn more about the fed funds rate hike in this post from MagnifyMoney, a LendingTree company.
If you choose a hybrid mortgage, you can also opt to refinance later to a fixed-rate mortgage. Just keep in mind that a change to your home value (or other factors like your credit) can impact your ability to get approved. You can compare products for new purchases and finances here.
When a hybrid mortgage is not right for you
Consider a fixed-rate mortgage if you value certainty. Hybrid mortgages should probably be avoided if you have some major expenses coming around the time frame your loan will begin adjusting. If you’re sending a child to college, planning for a wedding or paying for another major life event, even small increases to your payment could add pressure to your finances. A fixed-rate mortgage is safe and can be far easier to work into your budget.
Ultimately, taking out a mortgage that has an adjustable rate period — even if it’s later in the loan term — is taking on a risk. There are limits for how much your rate can increase, but the reality is that your payments could increase substantially. Speak with a lender so you’re clear on the conditions of the hybrid mortgage before moving forward.
Disclaimer: This article may contain links to MagnifyMoney, which is a subsidiary of LendingTree.