Long ago there used to be something called two-step or hybrid mortgages. We still have them today but now a new form of hybrid mortgage has begun to emerge -- a 15/15 ARM money-saver which borrowers may find very appealing.
Doing the Two-step
Let's start with the traditional two-step: It's simply an ARM with two interest rates: First, there's a start rate that typically lasts for three, five, seven or 10 years. Second, after the start period, the loan becomes a one-year ARM where the rate adjusts annually.
You may have seen two-step ARMs advertised. Their names reflect their terms -- the first number is the length of the introductory period, and the second number describes the number of years between adjustments -- so a 5/1 ARM is fixed for five years and adjusts every year thereafter; a 3/3 ARM is fixed for three years and adjusts every three years thereafter.
Like all ARMs, two-step mortgages have certain complexities. For instance, the start or teaser rate is always lower than the prevailing rate for fixed-rate mortgages at the time the loan is originated -- otherwise, you would simply want a fixed-rate loan. Today, as an example, you might find 30-year fixed-rate financing at 4.15 percent while a 5/1 ARM might have a 3.25 percent start rate and a 7/1 loan might be priced at 3.50 percent. In other words, the longer the start period, the higher the rate.
A second consideration concerns rate caps. ARMs have three rate caps: the initial adjustment, each subsequent adjustment, and the lifetime rate may all be limited. For example, a 5/1 mortgage might have a start rate of 3.1 percent, and after five years it could adjust upwards by a maximum of three percent, to a rate of 6.1 percent. Every year thereafter, it might adjust upward a maximum of two percent, and over its lifetime, the loan's rate can never go higher than six percent above the start rate, or 9.1 percent. Mortgage lender's would describe these caps as 3/2/6.
However, some loans have caps that look like this: 6/2/6. Such a cap arrangement means the loan could reach its lifetime cap at the first adjustment, an event which is unlikely but if it happens the borrower might instantly face shockingly steeper monthly costs.
The 15/15 ARM Money-Saver
A number of lenders, especially credit unions, have begun to offer a very different type of two-step loan. It's a 15/15 ARM and it's a product which may become vastly more popular.
With a 15/15 ARM, the loan has a 15-year "start" rate and then -- one time -- the loan adjusts for the rest of the loan term. Lenders and borrowers split the risk of inflation -- at least on paper. In fact, it could be argued that borrowers get the better end of this deal:
Imagine that interest rates today for fixed-rate financing are at 4.15 percent. In this illustration the borrower is saving .25 percent (4.15 percent less 3.9 percent). That doesn't sound like a big deal but if you have a $175,000 loan, you'll cut your financing costs by about $437 in the first year.
How the 15/15 ARM Mortgage Works
If you look at the 15/15 ARM, you can see some interesting characteristics.
First, the start rate is locked in for 15 years. Ask yourself: How many mortgages have you had that long? The odds are very good that you sold or refinanced long before 15 years, so the rate adjustment is a non-issue for you.
Second, you can save money. In our model situation, we have a $175,000 mortgage. At 4.15 percent over 30 years the monthly payment is $850.68 for principal and interest. With the 15/15 hybrid the rate is 3.90 percent and the monthly payments are computed on a 30-year schedule. For this reason the monthly cost for the two-step loan is $825.42 per month during its first 15 years.
At the end of 15 years the loan balance for the hybrid mortgage will be $112,350 versus $113,845 for the 30-year mortgage -- a savings of almost $900. In addition, the hybrid borrower paid $4,547 less interest. In total, the hybrid borrower saves over $5,000 in this illustration.
But what about that higher rate looming in the future for the 15/15 borrower?
Most borrowers will not have the loan for 15 years, so the rate change literally doesn't matter. However, if the original borrower sticks with the loan and the rate rises a full six percent from 3.90 percent to 9.90 percent, then a new cost will apply. The trick is that after 15 years, the borrower will only owe $112,350 and not the original $175,000. The new monthly payment will be based instead on the remaining balance. In this case, $112,350 at 9.90 percent over 15 years -- the remaining loan term -- gives us a monthly payment of $1,200.45.
There's no doubt that $1,200.45 is more than $825.42 but a little perspective is in order. First, we have created the most extreme example for a loan with a 6-percent rate cap. It's entirely possible that the rate will not go up that much and -- in theory at least -- the rate might actually decline. Second, the value of money in 15 years is likely to be very different. For instance in 1999 -- 15 years ago -- the typical existing home sold for $121,956 according to the National Association of Realtors. Today the typical existing home sells for $201,100. Why? In large measure because of inflation, today's dollars buy less.
Will 15/15 ARMs become more common? Given that mortgage investors may be unwilling to make 30-year commitments in the future, the 15/15 loan could become markedly more popular -- especially if the start rates given to borrowers represent real savings