Is
a hybrid mortgage right for you?
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.
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 pros
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 |
| 10/1 |
6.8% |
$978 |
| 7/1 |
6.4% |
$938 |
| 5/1 |
6.0% |
$899 |
| 3/1 |
5.6% |
$861 |
| 1-year ARM |
5.2% |
$824 |
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.
The cons
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.
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