Should You Drive a Hybrid?
Exploring Adjustable Rate Mortgages
It’s a popular consideration today. It seems nearly everyone offers some sort of a hybrid and it’s not just from Detroit, Japan or China; it’s from your mortgage company.
A hybrid, in mortgage-land, is a loan program with an interest rate that is fixed for a predetermined period of time and converts to an annual adjustable rate mortgage at the end of the initial, fixed rate period. For example, a hybrid can be fixed for 3, 5, 7 or 10 years before changing into a one year adjustable rate loan.
Let’s look at how one of the hybrids work in practice with a 5/1 hybrid loan.
A 5/1 hybrid will offer an interest rate slightly lower than a traditional 30 year fixed, hence their appeal. For instance, if a 5/1 hybrid is on the market for 2.75 percent then a 30 year fixed rate can be found in the 3.25 percent range. For five years, the borrower enjoys lower monthly payments due to the lower rate offered by the hybrid loan.
At the end of the five year period, the loan converts to a one year adjustable rate mortgage, or 1-year ARM. An ARM has three basic characteristics, an index, margin and caps.
Index: The index is the base number used to help calculate the mortgage rate at the adjustment period. A common index for ARMs can be the London Interbank Offered Rate, (LIBOR) or the 1-year Constant Maturity Treasury index, (CMT).
Margin: The margin is the amount added to the index to arrive at the borrower’s new interest rate. Common margins are 2.00 to 2.50 percent. If the CMT index is 0.15 percent and the margin is 2.25 percent, the new rate used to calculate monthly payments is 0.15 + 2.25 = *2.40 percent and will remain at 2.40 until the next adjustment period.
Caps: Caps are limits placed on the increase or decrease come adjustment time. Typical caps are 1.00 or 2.00 percent at each adjustment. Regardless of what the index plus margin adds up to, the new rate can’t be any higher than 1.00 percent above the previous rate.
There are two other types of caps for hybrids, one limiting the change at the first adjustment, called the initial rate cap, and a cap limiting how high the rate can be over the life of the loan, called lifetime caps.
Should you take a hybrid loan?
Hybrid loans offer lower start rates extending from 3 to 10 years when compared to many fixed rate mortgages. Yet while their rates may be lower inherently they’re still an ARM. Fixed rates are predictable and ARMs not so much. Even with lifetime caps on hybrids, interest rates could ultimately be 8.50 percent or higher at some point it the future.
However, if you’re a borrower that intends to sell the property or otherwise dispose of the mortgage within just a few years, then it does make sense to consider a hybrid loan. Interest rates will vary based upon the initial loan term, with 10/1 hybrids having higher rates compared to a 3/1 loan. And rate caps on hybrids limit annual increases on interest rates, helping to control interest rate swings. Consider them carefully, but if it’s a fit, drive one off your mortgage company’s lot today.
*Rates mentioned are for illustration purposes only.
Rates. Integrity. Service.