Hybrid Mortgage

Today's rising home prices and rising interest rates can make the financing process stressful. These situations challenge a borrower to come up with a great deal of cash for a large down payment, or to stretch to qualify for a larger mortgage.

To alleviate this situation, a borrower may choose an adjustable-rate mortgage (ARM), instead of a fixed-rate loan. The ARM's lower initial interest rates make qualifying for a mortgage easier, and initial monthly payments cheaper. However, if a borrower is not comfortable with ARMs because the monthly payments could possibly increase, there is a "third way" that combines the stable interest rates of a fixed mortgage with the lower initial interest rate of the ARM. This "third way" is the hybrid mortgage.

Hybrid mortgages come in a number of varieties, each with its own risks and benefits, as the descriptions and illustration tables in this article show.

The following article discusses what the hybrid loans are, how they work, and their pros and cons, so that a potential homeowner can determine if this type of loan suits their needs.

The home-buying process is full of decisions, and one of the first ones a borrower makes concerns financing. What kind of mortgage suits their financial needs and goals?

Today's atmosphere of rising home prices and rising interest rates makes the financing process stressful. The borrower's challenge is to come up with a great deal of cash for a large down payment, or to stretch in order to qualify for a larger mortgage.

The solution to this dilemma has been for borrowers to opt for an adjustable-rate mortgage (ARM), instead of a fixed-rate mortgage, because ARMs have lower initial interest rates. The lower initial interest rate enables the borrower to qualify for a larger mortgage, alleviating the need for a large down payment. Additionally, an ARM enables the borrower to enjoy lower monthly payments than they would with a fixed loan, at least for a while.

Borrowers who are not comfortable with an ARM because of a concern about the risk involved with having a mortgage whose interest rate can rise over time, they may elect a "third way." This "third way" is known as the "hybrid" or combined mortgage, which combines the stable interest rates of a fixed mortgage with the lower initial monthly payments of an ARM.

This article focuses on hybrid mortgages, and enables potential homeowners to decide if a hybrid meets their financial needs and goals, by answering the following questions about it:

• What is a hybrid mortgage?
• How does it work?
• What are the pros and cons?

What is It?

As its name implies, a hybrid mortgage combines the low rate feature of an ARM with the payment stability of a fixed-rate loan.

A hybrid mortgage can start out with a fixed rate for a period of time, and then become adjustable after a designated deadline. Conversely, they can also start out as adjustable and then become fixed.

Hybrids come in different varieties:

• Fixed-period adjustable-rate mortgages (ARMs)
• Two-step mortgages * Convertible ARMs
• Graduated payment mortgages (GPMs)
• Buydown mortgages
• Balloon mortgages

How does it work?

Fixed-period ARMs

Fixed-period ARMs are usually tied to the one-year Treasury securities index.

With a fixed-period ARM, the borrower gets three to ten years of fixed payments before the initial interest rate changes, or adjustment, occurs. As with many traditional ARM products, the interest rate will adjust once each year.

One can tell whether a loan is a fixed-period ARM by examining the names. Typically, fixed-period ARMs have "three number" names, as follows:

1. 30/3/1
2. 30/5/1
3. 30/7/1
4. 30/10/1

The numbers indicate the following:

• The first number shows the years of amortization (30 years)
• The second number indicates the number of years for which the initial interest rate will be fixed (3, 5, 7 or 10 years)
• The last number indicates how many times per year the interest rate will adjust after the fixed period ends (1 time per year).

The main advantages of a fixed-period ARM are similar to those of a traditional ARM. With these loans, a borrower receives:

• A lower interest rate for the initial fixed period than they would for a fixed-rate mortgage. This is because the lender is not locked in for as long, so their risk is lower and they can charge less.
• Caps (or ceilings) to protect the borrower from large payment spikes. By law, all ARMs must have a lifetime cap, or a ceiling above which the interest rate cannot go for the life of the loan. Also, many fixed-period ARMs have a first adjustment cap in addition to the lifetime cap. In other words, there may also be a limit to how much the interest rate can go up on the first adjustment.

The main disadvantage of a fixed-period ARM is also similar to that of a traditional ARM: as time goes on the interest rate can rise, and so can the monthly payments. However, if the borrower intends to sell or refinance the home once the initial period or first adjustment ends, or if they have sufficient income to meet the potentially higher payments, then this does not have to be an issue.

An additional disadvantage of the fixed-period ARM is that its initial rate tends to be slightly higher than is the rate for an ARM with a short initial period (e.g., the 1-year ARM).

Two-step mortgage

Two-step mortgages start off with a rate that is usually lower than the prevailing market rate for a fixed-rate loan. After a designated period of time the interest rate changes to a current market rate and remains the same for the life of the loan.

The two most common two-step mortgages are:

• The 5/25 two-step mortgage. This loan offers an initial five-year fixed rate. After the initial period, there is one rate adjustment, and the adjusted rate stays the same for the remaining 25 years of the loan.
• The 7/23 two-step mortgage. This loan offers an initial seven-year fixed rate. After the initial period, there is one rate adjustment, and the adjusted rate stays the same for the remaining 23 years of the loan.

As with fixed-period ARMs, the advantages of two-step loans are similar to those of traditional ARMs. With a two-step loan, the borrower:

• Qualifies with a low starting interest rate
• Get stables, predictable payments for the first five or seven years and then, after the adjustment, for the remaining 25 or 23 years of the loan
• Is protected from rising interest rates during the early years of home ownership
• Has time to increase their earnings or assets before the rate adjustment at the end of five or seven years

As with fixed-period ARMs, the main disadvantage of this loan type is that the monthly payment is likely higher after the adjustment. Here again however, if the borrower intends to sell or refinance the home once the initial period or first adjustment ends, or if they have sufficient income to meet the potentially higher payments, then this does not have to be an issue.

Convertible ARMs

As their name implies, convertible ARMs allow the borrower to start with a low adjustable interest rate. The initial period for convertible ARMs is usually 1, 2, 3 or 5 years.

Then, the buyer can convert to a fixed rate at a designated time (which varies by loan program). The new rate is based on the current market rate for fixed-rate mortgages, but is usually a little higher.

Convertible ARMs come with a number of advantages; one gets:

• Lower initial rates
• The ability to convert and lock in a fixed rate if they see rates starting to rise

Conversion to a fixed rate without the associated paperwork and costs of refinancing

The main disadvantage of the convertible ARM is that the conversion interest rate is usually a little higher than the going market rate. However, if the main concern is locking in a stable rate in a time of rising rates, then this is not likely to be an issue.

Graduated payment mortgages (GPMs)

As opposed to an ARM, GPMs have a fixed note rate and payment schedule (either for 15 or 30 years).

However, similar to ARMs that have payment caps, GPM monthly payments start off low and gradually increase, usually once a year, until they reach what the 15-or 30-year monthly payment ought to be. The yearly increase is usually to a percentage of the previous payment. Different loans have different schedules of increases.

The following example compares what a borrower would pay on a $250,000 graduated payment schedule versus a 30-year fixed-rate at 6%.

In this example, the annual increases are scheduled for 5 years. Once a year for 5 years, the borrower gets a payment increase of 7.5%. At the end of the five years, those increases stop and the borrower pays the 30-year amortizing rate every month for the remaining 25 years of the loan.

A GPM may be right for a borrower if:

• They are a first-time home buyer who currently does not have the resources to afford a high monthly mortgage payment
• They can project what their income is in the next few years, so that they know whether they can afford the increased payments
• They want a loan that has no surprises. All factors of the GPM, including how much the payments increase and when, are documented and scheduled.

However, a borrower should be aware that GPMs carry the risk of negative amortization. Negative amortization occurs when payments do not cover the cost of the interest, and this in turn will result in the loan balance increasing until the payments do cover the cost of the interest.

GPMs usually will be negatively amortizing in the early years of the loan, and then the borrower pays off the principal at an accelerated pace through the later years, once the payments are large enough to cover the cost of the interest.

Buydown mortgages

A buydown mortgage is one in which the buyer or seller makes an initial lump-sum payment to reduce the interest rate on the loan. This initial payment is referred to as "paying points," or paying extra interest points up front in exchange for a discount on the loan.

There are two types of buydown mortgages: permanent and temporary.

A permanent buydown lets the seller/builder pay extra points up front to get the buyer a discounted interest rate over the life of the loan.

Sometimes sellers/builders will pay for a permanent buydown in order to:

• Create a lower monthly payment that will incent the buyer to complete a sale
• Move a difficult to sell property
• Move a property during slow market conditions

As a buyer, he or she would benefit from having increased ability to qualify for a loan, as well as from the lower monthly payment.

A temporary buydown lets a borrower prepay interest in exchange for a lower rate during the first few years of the loan.

The most common temporary buydown loan is the 3-2-1. This means that:

• In year one, the monthly principal and interest payment is 3% lower than the full interest rate of the loan
• In year two, the monthly principal and interest payment is 2% lower than the full interest rate of the loan
• In year three, the monthly principal and interest payment is 1% lower than the full interest rate of the loan
• From year four onward, the monthly principal and interest payment would be at the full interest rate of the loan.

Variations on this loan type include the 2-1 and the 1-0 buydown.

A temporary buydown's advantages are similar to those of other loans discussed above. In particular, a temporary buydown can benefit a borrower if income is initially low, but the borrower anticipates their income rises over the next two years.

As is the case with other loans discussed above, the main disadvantage of the temporary buydown is that the monthly payment will increase. However, one knows in advance when and by how much, so they can plan for that increase.

Balloon mortgages

Balloon mortgages are short-term, fixed-rate loans with set monthly payments for a designated number of years. At the end of the designated term, a final "balloon" payment is due for the remainder of the principal.

The most common balloon mortgages are:

• The 5/25 - With this loan, one makes low monthly payment for 5 years, and then at the end of year 5 pays off remaining principal.
• The 7/23 - Similar to the 5/25, with this loan the borrower would make the low monthly payment for 7 years, and then at the end of year 7 pay off all the remaining principal.

A balloon mortgage is not a typical option for borrowers; in fact, it tends to be a last resort for people who can't get a more conventional loan.

A balloon mortgage can benefit a borrower by:

• Giving a low initial interest rate
• Keeping initial monthly payments low
• Enabling the purchase of "more house" than one could buy with a conventional loan, because the qualifying rate and monthly payments are lower.

The main disadvantage is the balloon payment after the first five or seven years. If the borrower cannot make that payment, sell or refinance the home before that time, they could default on the mortgage and lose the home.

What are the pros and cons?

As we have seen, a hybrid is an appropriate choice if the borrower wants "the best of both worlds", or the low initial interest rates of an ARM combined with the interest rate stability of a fixed mortgage.