Hybrid mortgages provide the benefits of both fixed and adjustable rate options. They usually feature a fixed rate period of three, five, seven or 10 years.
A hybrid mortgage offers the lower starting rate of a fixed-rate period, but that comes with some risk. If you don’t anticipate any major life changes before then, taking this chance could be worth taking for the initial savings.
Fixed-rate period
Hybrid mortgages are a combination of fixed rate loans and adjustable-rate mortgages, offering homeowners the security of locking in a low interest rate for an extended period. However, it’s essential to remember that these loans also carry risks such as higher payments or rate increases after the introductory fixed-rate period ends.
Hybrid mortgages typically feature an initial fixed-rate period of three, five, seven or 10 years. This initial fixed rate is known as a “teaser” rate and may be lower than the rate on an adjustable-rate mortgage (ARM).
The lender begins with an index, which is the benchmark variable interest rate, then adds a spread or margin. The amount of this spread depends on many factors including your credit history and score.
After the fixed rate period ends, your loan becomes an adjustable-rate mortgage and your interest rate adjusts periodically for the remainder of its term. This adjustment period may start as soon as one year from when you took out the mortgage.
Most ARMs include an initial rate cap that restricts how much your interest rate can change on your first adjustment after your fixed-rate period ends. This cap can be set at a percentage point or more below the index rate, so you won’t see a sudden surge in your monthly payment.
Another type of cap is a lifetime adjustment cap, which restricts how much your interest rate can rise over the life of the loan. These caps help borrowers prevent interest rate shock and the possibility of defaulting on their mortgage payments.
A VA hybrid ARM is an example of a hybrid mortgage that offers an initial low interest rate and lifetime cap to protect you against large increases in rates. This allows you to save thousands in interest during the hybrid’s initial period and pay off your mortgage faster.
Adjustable-rate period
Hybrid mortgages combine the benefits of both fixed rate and adjustable rate loans, giving you access to both types of loans. They come in various forms but are most popular for home loans due to their low initial interest rate that may enable refinancing at a lower interest rate after your fixed-rate period ends.
A 10/1 ARM, for instance, features a fixed rate for the first 10 years of the loan. After that, it adjusts according to general market conditions. On the other hand, a 5/1 ARM offers an initial fixed rate of five years which then fluctuates according to current rates.
If you’re uncertain which loan type is ideal for you, a great place to begin is by reviewing your financial goals and current spending habits. Doing this will enable you to decide if an adjustable-rate mortgage is the most advantageous choice for you.
One of the primary advantages of a hybrid mortgage is its lower initial interest rate, which could save you hundreds of dollars over its life.
Depending on which hybrid mortgage you select, your interest rate may be adjusted annually or multiple times. This adjustment is calculated based on a combination of margin and an index set by the lender.
These indexes include the cost of funds index (COFI), one-year constant maturity Treasury securities or London Interbank Offered Rate (LIBOR). They’re calculated based on several factors, such as recent economic developments and your credit score.
Some lenders also factor in other criteria to the index, such as your credit history and debt-service ratio (DSCR). This margin can fluctuate over time according to changes in economic conditions.
Additionally, many mortgages have limits on how much their interest rate can adjust up or down after the initial fixed-rate period ends. These caps protect homeowners from being hit with a large payment when their loan adjusts – something which could prove hazardous in the long run.
On hybrid ARMs with fixed rate periods of three years or less, the initial cap is usually set at 1 percentage point; on those with longer fixed-rate periods of five years or more, two percentage points. Furthermore, lifetime adjustment caps limit how much an interest rate can increase throughout the loan’s lifespan.
Caps on interest rate adjustments
Hybrid mortgage interest rate caps are designed to prevent your payment from increasing significantly during a rate increase or decrease. Not only do they protect you from large changes in rates, but they also guarantee that you don’t end up paying higher interests over the life of the loan.
Most ARMs will include an initial cap that limits the rate your loan can adjust to, as well as a periodic cap which restricts how much can change during each adjustment period. For instance, a 5/1 ARM would have an initial cap of 2% and 1% respectively.
In addition to these caps, some hybrid ARMs also include a lifetime cap. These limits, often referred to as ceilings, are regulated by Fannie Mae or Freddie Mac to protect lenders from borrowers who might struggle financially if interest rates suddenly increase significantly.
Hybrid ARM loans use an index, which is the benchmark interest rate that your loan uses to calculate its mortgage rate. Usually this index will be either the Secured Overnight Financing Rate (SOFR) or another comparable alternative index.
On top of the index value, lenders add a margin. This combination creates the fully-indexed rate that your loan will be tied to and serves as the basis for calculating your interest rate.
When signing up for an ARM, the lender will provide you with a rate quote that includes your interest rate plus whatever margin they add to the index value. This margin, which varies from lender to lender, represents the difference between the index value and your loan’s interest rate.
According to the hybrid ARM you choose, there may be other limits on interest rate adjustments. These are sometimes referred to as “two and six caps” or “periodic and lifetime caps”.
Fannie Mae and Freddie Mac typically feature these caps on their new hybrid ARMs; however, some private lenders offer different cap structures as well – be sure to inquire about them prior to signing on the dotted line.
Fees
If you’re a homebuyer who wants to take advantage of low interest rates but don’t want the full burden of a long-term mortgage, hybrid mortgages could be for you. Unfortunately, their popularity hasn’t grown as quickly as some might hope; according to Mortgage Professionals Canada only one out of every 25 borrowers opt for this type of loan.
Hybrid mortgages enable you to divide your loan into two or more portions, each with its own fixed and variable rate structure, term, and payment schedule. This gives you the benefit of spreading payments over time while minimizing market fluctuations.
At renewal, however, you’ll pay a premium for this flexibility; your mortgage must be refinanced and transferred to another lender. Refinancing fees can add up to several percentage points onto the cost of your loan – particularly for smaller ones.
Before signing on the dotted line with a hybrid mortgage, it’s essential to carefully consider all its components. Be aware that certain fees associated with these loans may not be included in your total mortgage amount – such as appraisal, title insurance and legal services.
As with standard mortgages, hybrids often come with higher closing costs compared to their standard counterparts; however, the lower introductory interest rates that hybrids often offer can often make up for this difference.
Furthermore, most lenders provide limits on how quickly and how much your interest rate can adjust. These safeguards help ensure you don’t pay more than necessary on your mortgage – particularly beneficial when market indexes are low.
A hybrid mortgage offers you the unique flexibility of selecting your terms (contract lengths) in almost endless combinations. For instance, you could put one-third of your loan in a three-year fixed rate period and the remaining two thirds into an adjustable-rate mortgage for ten years.
If you’re a first-time homeowner with little credit history, a hybrid mortgage could be your ideal solution. A hybrid mortgage combines the stability of a fixed-rate mortgage with the versatility of an ARM, while managing your interest rate risk and building equity at the same time.