Most homeowners understand the difference between fixed-rate and adjustable-rate mortgages (ARMs). A hybrid mortgage, as its name suggests, combines the features of both. It starts off like a fixed-rate mortgage, with a stable interest rate for up to ten years. But then it converts to an ARM, with the rate being adjusted every year for the remaining life of the loan.
How does it work?
On mortgage charts you’ll see hybrids referred to as 3/1 or 5/1, and so on. The first number is the length of the fixed term -- usually three, five, seven or ten years. The second is the adjustment interval that applies when the fixed term is over. So with a 7/1 hybrid, you pay a fixed rate of interest for seven years; after that, the interest rate will change annually.
So is a hybrid mortgage the best of both worlds, or the worst? That depends on how long you plan to stay in your home and your tolerance for risk.
The most appealing thing about a hybrid mortgage is that -- initially, anyway -- you pay less interest than with a fixed-rate loan. As a rule of thumb, the rate of a 5/1 hybrid is about one percent below that of a 30-year fixed-rate mortgage.
Let’s say you need to borrow $150,000. Here’s how your payments might differ:
Type of mortgage
|Interest rate (estimated)||Monthly payment (for fixed term)|
|30-year fixed rate||7.0%||$998|
The 3/1 option in this example offers a monthly payment almost $140 less. Sure, you can go even lower with a one-year ARM, but you wouldn’t have the same peace of mind. Since you may face unexpected expenses after moving, a consistent monthly payment for three or more years can be comforting -- especially when the interest rate is only marginally higher than an ARM.
Of course, these lower monthly payments don’t come for free. After your fixed term is up, your interest rate is adjusted and it could increase dramatically.
Most hybrid mortgages protect you from huge swings in interest rates by setting a maximum increase -- typically two percent per year, and six percent for the lifetime of the loan. But this cap doesn’t necessarily apply to the first year after your fixed term is up.
Say you get a 5/1 mortgage at six percent. If rates climb to eight or nine percent during the next five years, your monthly payments could suddenly get a lot bigger when your fixed term is up.
Who should consider one?
Most experts agree that hybrid mortgages are not a good choice for people who plan to be in their home for 10 years or more. It’s usually not worth sacrificing the security of a fixed-rate mortgage for the savings you’d achieve with a 10/1 or even a 7/1 hybrid.
At the other end of the scale, if you plan on keeping your house for less than three years, a one-year ARM is likely the best option.
However, most people sell their homes or refinance after five to seven years, and it’s these homeowners who should consider a hybrid mortgage. While the 3/1 rates may be tempting, you’ll have greater flexibility if you sign on for a slightly longer fixed term. A 7/1 hybrid will give you an interest-rate break and allow you to move or refinance at a fixed rate before the adjustable rate kicks in, but you may be subject to penalties.