Interest rates are rising, and according to most experts, they are likely to continue rising through 2014, and perhaps beyond. If you are ready to purchase a home, you recently missed out on historically low interest rates for fixed-rate mortgages. While interest rates on fixed rate mortgages are still relatively low, you may also wish to consider an adjustable rate mortgage (ARM) to keep your monthly payments lower in the initial years. In that case, you should consider a hybrid mortgage.
Hybrid mortgages contain elements of both fixed-rate and ARM mortgages. The typical arrangement for a hybrid loan is an initial fixed rate for a set period, switching to an adjustable rate after that period expires. Hybrid loans are known by a two-digit label referring to the length of the fixed rate period followed by the period of adjustment. For example, a 5/1 loan has a fixed rate for five years, and the rate adjusts annually after that. (Most hybrids adjust the rate annually.)
Many homebuyers, expecting a continued rise in interest rates, are afraid of standard ARMs and are opting for the relative stability of a hybrid mortgage. According to a Freddie Mac survey of ARM loan offerings in January 2014, the most popular hybrid loans were 5/1, with 3/1, 7/1, and 10/1 terms not too far behind. Rates will differ based on the term, with lower rates for lower fixed terms. For reference, recent 5/1 loans were available near 3.4% and 10/1 loans near 4.2%. This is compared to current 30-year fixed rates at around 4.6%.
In general, 5/1 ARM's with 30-year terms are running 1.1% to 1.3% lower than 30-year fixed rates, and 0.1-0.4% lower than a 15-year fixed rate. For reference, on a $250,000 5/1 mortgage, a 1.3% difference in interest rate in today’s market makes a difference of about $190 in the monthly payments over the five-year fixed term, or a little over $11,000 total.
A hybrid mortgage may be a good choice if you intend to stay in the house only through the fixed period of the loan. Examples: you have a job that requires frequent relocation, or you expect to start a family and may outgrow this house by the end of the fixed period. Verify that your loan does not carry any penalties for refinancing or early sale of the home prior to the adjustment period.
Hybrid loans are not without some degree of risk – it is always possible that when the adjustment period nears, the housing market is too depressed for you to sell your house. It's also possible for fixed interest rates to fall below your current value, although that seems very unlikely given the current Federal Reserve policy to ease up on their bond buying that is keeping interest rates low.
The other risk associated with hybrid loans is that the interest rates will rise sharply in the variable portion of the loan before you can acquire viable refinancing options to lower the rate. The index used for adjustment could be any one of several common indices, such as the Cost of Funds Index (CFI) or the London Interbank Offer Rate (LIBOR); some of these indices are quite volatile, and thus prone to producing a higher adjustment.
You have some protection through yearly and lifetime caps on the interest rates (typically 1-2% annual with a 6% lifetime cap), but there may still be a huge difference in your payments and overall costs. Let's consider the above example of a $250,000 5/1 mortgage.
Start with a 3.4% interest rate and a 6% lifetime cap (meaning that the total change in interest rates over the life of the loan term cannot exceed 6%; in this case your top interest rate would be 9.4%). If interest rates rise 1% per year after the 5-year fixed period and you are paying 9.4% in years 11-30, your monthly payments will increase to $1,872.66 from their original $1,108.70, and you will pay $355,119.24 in interest over the life of the loan. Compare that to a 30-year fixed loan at 4.6%, where all of your payments are $1,281.61 and the total interest payment over the life of your loan is $211,377.13 – over $140,000 less!
In this case, should fixed interest rates rise to 9.4% during the 11 years of combined fixed/adjustment period – certainly a reasonable possibility – you won't have any refinancing options better than your current interest rate, and will be lamenting that 4.6% fixed rate you could have had 11 years ago.
The point is that hybrids, like any ARM, still contain risk. The perfect situation for a hybrid mortgage is that interest rates rise sharply over the period of the fixed portion of the term, and fall back to previous levels before the adjustment period kicks in. In that case, you should be able to refinance easily – or you may not want to.
In the grand scheme of things, fixed-interest rates are still a pretty good deal – so if you plan to stay in your home for a long time, locking in on current rates is probably best. But if you plan to stay in your home for a shorter time, you can handle the risk, and you can find a good deal with fixed terms that match your expected stay in the home, a hybrid mortgage may be the best choice for you.