What is a Hybrid Mortgage?
A hybrid mortgage combines features of a fixed-rate mortgage and an adjustable-rate mortgage (ARM). Hybrid mortgages have a fixed interest rate for a specific period of time; after that, the rate adjusts periodically for the remaining loan term. For example, you may have a fixed interest rate for the first 10 years, and then an adjustable rate for the next 20 years.
As your loan’s interest rate adjusts, so will your monthly payment amount. This can work to your advantage — but if you’re caught off guard, it can lead to financial strain and even foreclosure.
How does a hybrid mortgage work?
When shopping for a hybrid mortgage, you’ll often see them listed in the following format: 3/1, 5/1 or 7/1. The first number denotes how many years the mortgage rate is fixed, and the second number tells you how often (in years) the rate will adjust after that. So, a 5/1 ARM rate adjusts once per year after an initial five-year, fixed-rate period.
Initial rate
The main benefit of a hybrid mortgage is the initial fixed rate, because it’s typically lower than the interest rate on a fixed-rate mortgage. This lower rate usually means a lower monthly payment, making the hybrid ARM loan more affordable in the first few years. However, once the rate adjusts, it could increase or decrease — affecting your monthly payment.
What is a teaser rate?
A teaser rate is a low interest rate that’s even lower than the hybrid ARM’s fixed rate. It goes into effect at the very beginning of the loan term, before the normal fixed-rate and adjustable-rate periods. Lenders use teaser rates to attract customers to their hybrid ARM products.
Interest rate adjustments
Mortgage lenders determine the interest rates for a hybrid mortgage by adding two key factors together: an index and a margin.
An index is the benchmark rate lenders use in their calculations when they adjust the interest rate on a hybrid ARM loan. The index gives them a starting point for their calculations, since it reflects the baseline cost of borrowing money in the market on that day.
A margin is a number of percentage points the lender adds to the index to determine the final interest rate. Some lenders may use your credit score and history to determine what margin they add to the index.
The “fully indexed rate” on an ARM is just your rate once the margin and index are added together.
Interest rate caps
Although the interest rate on a hybrid mortgage can change over time (which could affect your monthly payment), there are limits on these adjustments. These limits are called “caps,” and a loan’s caps are often expressed as three numbers separated by slashes — for example, “5/2/5.”
In order, the three caps are:
- Initial adjustment cap: This cap refers to the first rate adjustment your lender can make after your fixed rate ends. Typically, the cap is either 2% or 5%, which means the initial rate can’t go up by more than 2 or 5 percentage points.
- Subsequent adjustment cap: This cap refers to all remaining adjustments after the initial rate adjustment. In most cases, the rate can’t increase by more than 2 percentage points in any single adjustment.
- Lifetime adjustment cap: This cap refers to the total rate increase over the life of the hybrid mortgage. A common lifetime adjustment cap is 5%, which means your interest rate can never be more than 5 percentage points higher than the initial interest rate (the fixed rate you started with was), even if the broader market shoots up.
Check your loan offers for caps
The rate caps mentioned above are common, but lenders can set their own limits, so it’s important to review what those caps are before committing to a loan. Ideally, you should also compare offers from multiple lenders to see how their loan cap structures differ — and whether one might be more advantageous for you. For instance, if you plan to move in a few years, you may be more concerned with the initial rate cap than the lifetime adjustment cap.
Loan term
Today most hybrid adjustable-rate mortgages are fully amortizing 30-year loans, which means you’ll pay off an ARM in the same time-frame as a traditional 30-year fixed-rate mortgage.
Need more details on how ARMs work? Check out the Consumer Handbook on Adjustable-Rate Mortgages Booklet, which all lenders are required to provide to ARM loan borrowers.
Which loan programs offer hybrid mortgage options?
Conventional loans
- Freddie Mac offers hybrid ARM loans through conventional lenders with 3/6-month, 5/6-month, 7/6-month and 10/6-month loan terms.
- Fannie Mae has 7/6-month and 10/6-month hybrid ARM loan options available through conventional lenders.
Rate caps
- Freddie Mac’s 3/6-month and 5/6-month hybrid ARM loans come with 2/1/5 rate caps, while its 7/6-month and 10/6-month loans come with 5/1/5 rate caps.
- Fannie Mae’s hybrid ARMs come with 1/1/5 rate caps.
FHA loans
There are four hybrid mortgage products backed by the Federal Housing Administration (FHA) with fixed-rate periods of three, five, seven or 10 years.
Rate caps
- With a three-year hybrid ARM loan, the rate caps are 1/1/5.
- With five-year hybrid ARM loans, the rate caps are 1/1/5 or 2/2/6.
- All seven- and 10-year hybrid mortgages have a 2/2/6 rate cap structure.
VA loans
Hybrid mortgage loans available through the U.S. Department of Veterans Affairs (VA) offer fixed-rate periods of three, five, seven and 10 years.
Rate caps
- The rate caps for loans with a fixed-rate period of less than five years are 1/2/5.
- For hybrid mortgages with a fixed-rate period of five years or more, the initial adjustment cap is 2/2/6.
USDA loans
Pros and cons of a hybrid mortgage
Pros
Longer fixed rate. A hybrid mortgage could provide a longer introductory fixed interest rate than other ARMs.
Lower initial payments. With a lower introductory interest rate, it’s possible you’ll also enjoy a lower mortgage payment for a while.
Rate caps. With rate caps, you know your ARM rate won’t skyrocket when it adjusts.
Cons
Changing payments. Although there are rate caps in place, it can be stressful not to know how much you’ll owe when future payments come due. Rate increases can quickly become a burden that stretches your budget thin.
Possibility of foreclosure. If your payments become unaffordable and the loan goes into mortgage default, you could lose your home.
Risk of negative equity. If you choose an interest-only ARM and home values drop in your area, you could end up “underwater” — owing more than the home is worth.
Tip: Know your maximum payment
One great way to avoid getting into a hybrid ARM that will later become unaffordable is to find out what the maximum payment is before committing to an ARM. You can either ask the lender to calculate this for you, or review the payment estimates in the “Adjustable Payment Table” on Page 2 of your loan estimate. It can also help to look at the “Projected Payments” section of your closing disclosure, which shows the range you can expect your payments to fall within for each rate adjustment.
Is a hybrid mortgage right for me?
A hybrid ARM loan makes sense if:
- You need a lower mortgage payment for a short time. A lower payment could help you build up an emergency fund, bulk up your retirement savings or fund other important financial goals.
- You’ll be paying down your principal for a future loan recast. With a lower interest rate upfront, more of your payment is applied to the principal balance, which could make it easier to recast your loan and lower your monthly payment amount.
- You’re expecting a large raise. If you expect a promotion or salary bump before the fixed-rate period ends, a hybrid mortgage could provide a way for you to get a home loan now, knowing you’ll be in a good position to make payments after the fixed-rate period ends.
- You’ll be refinancing or selling the house before the rate adjusts. If you don’t plan to remain in your loan for the entire fixed-rate period, a hybrid mortgage could be a great option. You’ll get to purchase a home at a low interest rate, without making those bigger monthly payments that would likely come down the line with a hybrid ARM.