f you're thinking of buying a house, you've probably become a rate-watcher. You've noticed the 30-
year, fixed-rate mortgage hovering around 8%. Maybe that works out to a monthly payment beyond your comfort zone.
If so, a one-year adjustable-rate mortgage (ARM) may look enticing, with a rate roughly a percentage point lower than
the fixed rate.
On a $100,000 mortgage, that one percentage point decrease shaves $68 off your monthly payment. You'd welcome the savings now. But you know that when the year ends, your rate could climb a couple of percentage points, resulting in a monthly payment that strains your budget. You wonder, can I sleep at night if I take that risk?
Millions of home buyers before you have grappled with the same quandary. Fortunately, today's home buyers have an in-between option available. It's a cross between a fixed-rate mortgage and an ARM, appropriately named a hybrid mortgage, or hybrid ARM.
A hybrid mortgage offers a fixed rate for a specified time period, usually three, five, seven, or 10 years. When the fixed-rate period ends, the mortgage becomes a one-year ARM, with the rate subject to upward or downward changes each year through the remainder of the 30-year term. In the mortgage world's shorthand, hybrids are designated as 3/1, 5/1, 7/1, or 10/1.
A hybrid carries a lower interest rate than a fixed-rate mortgage, but a higher rate than a conventional ARM. In general, the longer the hybrid's fixed-rate period, the higher its interest rate. Thus, a 10/1 has a higher interest rate than a 7/1, and so on.
A hybrid carries a
lower interest rate
than a fixed-rate
mortgage, but a
higher rate than a
Is a hybrid right for you?
The answer depends partly on how long you plan to remain in your home. Say you intend to stay for five years. "If you're considering a 5/1 or 7/1 hybrid, you're essentially looking at a fixed-rate loan for the term that you'll be in the home," says Tracy Ashfield, president of Strategic Mortgage Solutions, a mortgage consulting firm in Middleton, Wis.
A hybrid mortgage may be a good choice if, for example, you know you'll move to a bigger house in three years because you're planning to start a family. Or perhaps you're certain a job transfer will send you to another city in five years.
Even if you're not planning a move, a hybrid still could be a good option if you foresee a major change in your life circumstances, Ashfield advises. For instance, to accommodate an expanding family, you might be planning to refinance your mortgage to build an addition on the home you're buying now, rather than moving to a larger house later.
"A hybrid fits a lot of people's needs," Ashfield points out. "Statistics show that homeowners are constantly turning over their mortgage loans." One 1998 industry study indicates that the median age of a mortgage when it was refinanced was four years.
Whatever your situation might be, evaluating whether a hybrid is right for you entails answering a key question: Does the time frame of the hybrid match how long you plan to be in this house and/or in this mortgage?
Some "what ifs"
You may have noticed stories in print lately about people opting for hybrids simply because they're sure rates will fall. History shows, they contend, that high interest rates last no more than five years. So today's somewhat high rates definitely will drop before the end of the fixed-rate period of, say, a 5/1 hybrid. At least, that's what they're betting on.
But Ashfield cautions against this approach. "It reminds me," she says, "of those people who tell me how to beat the odds at roulette." People with a rates-are-sure-to-fall mindset may suffer from a limited historical perspective, Ashfield notes. Yes, the current 8% rates on 30-year fixed-rate mortgages are high compared to the three-decade lows of about 6.5% we saw just a couple years ago.
But "high" is relative. Today's 8% rates are a bargain in contrast to the 18% rates of the early 1980s. Who's to say rates are now at the "high" point of the cycle and are destined to fall? What if rates climb? Could you afford the bigger payments?
Here's another "what if" to ponder. Say you get a 5/1 hybrid because you plan to move to a new house in five years. But circumstances change, and you have to delay your move for a year or two. Will you regret your decision to take a hybrid? Not necessarily. "It's not like the rate will skyrocket," Ashfield says, "because you have caps on the rate of the ARM portion of the hybrid."
Annual and lifetime caps limit how far the rate can climb (or fall) each year and over the life of the loan. A common combination is the "two and six," which designates that the rate can climb (or fall) no more than two percentage points a year and six percentage points over the life of the loan. For example, a 7% rate could jump as high as 9% at the first adjustment, and to no more than 13% over the life of the loan.
But with a 5/1 hybrid, for five years you paid a lower rate than you would have if you'd taken a 30-year fixed-rate mortgage. So even though you're unexpectedly still in the house after five years and you then may have to pay a higher rate for a year or two, you might still be money aheador at least break even.
Sizing up a hybrid
If you decide a hybrid fits your home-owning plans, you'll need to select which fixed term you want. Say you know your company will transfer you in five years and you'll be selling your home. You could give yourself some elbowroom, just in case your transfer gets postponed, by opting for a 7/1 hybrid instead of a 5/1. Is that smart, considering the 7/1 carries a higher interest rate?
"To answer that you have to look at the rate differential between the two hybrids," Ashfield says. "For instance, if the difference is only 10 basis points (as in 7.7% vs. 7.8%), I'd probably go with the 7/1 hybrid. But if it's a half percentage point difference (as in 7.3% vs. 7.8%), I'd probably go with the 5/1."
Check if the hybrid carries penalties if you refinance early, before the fixed-rate period expires. Also, be sure you understand the annual and lifetime caps on the ARM portion of the hybrid. Pay particular attention to what can happen at the first adjustment after the fixed-rate period. Some lenders don't apply the annual cap to the first adjustment; the rate hike could exceed the cap. Mortgage industry practices are getting more diverse and confusing, so find out what you're getting into.
You can trust your credit union mortgage lender to give you the straight story on hybrids, and to help you decide if that's the best mortgage choice for you.
The time frame
of the hybrid
how long you
plan to be in
this house and/or
in this mortgage.
Be sure you
annual and lifetime
caps on the ARM
portion of the hybrid,
and pay particular
attention to the
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