What is a Hybrid Mortgage?
Simply put, a hybrid mortgage combines features of a fixed-rate mortgage and an adjustable-rate mortgage (ARM). A hybrid mortgage is a home loan with a fixed interest rate for a specific period of time, after which the rate adjusts periodically for the remaining loan term. For example, with a 30-year, 10/1 hybrid ARM loan, the interest remains fixed for the first 10 years. The rate will then adjust each year for the next 20 years.
How does a hybrid mortgage work?
When shopping for a hybrid mortgage, you will often see them listed in the following format: 3/1, 5/1 or 10/1. The first number denotes how long the mortgage rate is fixed, and the second number tells you how often the rate will adjust.
Initial teaser rate
The main benefit of a hybrid mortgage is the initial fixed teaser rate, because it’s typically lower than the interest rate on a fixed-rate mortgage. This lower rate usually means a lower monthly payment, making the hybrid ARM loan more affordable in the first few years. However, once the rate becomes adjustable, it could increase or decrease — affecting your monthly payment.
Margin and index
Interest rates for a hybrid mortgage are determined using two key factors: margin and index.
A margin is the percentage points the lender adds to the index to determine the interest rate. Some lenders may use your credit score and history to determine what margin they add to the index.
An index is the benchmark variable rate lenders use to determine the interest rate for a hybrid ARM loan. There are three common indexes used for this purpose: the Cost of Funds Index (COFI), the one-year constant-maturity Treasury (CMT) securities and the London Interbank Offered Rate (LIBOR). These indexes routinely change based on current economic conditions, which is important to remember when shopping for mortgage quotes. Rate quotes you receive today could easily change tomorrow.
Interest rate and payment caps
Although lenders are able to adjust your hybrid mortgage interest rate, which could affect your monthly payment, there are limits to the adjustments they can make. There are three kinds of caps that affect rate adjustments, according to the Consumer Financial Protection Bureau:
- Initial adjustment cap: This cap refers to the first rate adjustment your lender can make after your fixed rate ends. Typically, the cap is either 2% or 5%, which means the initial rate can be increased by either 2 or 5 percentage points.
- Subsequent adjustment cap: This cap refers to all remaining adjustments after the initial rate adjustment. In most cases, the rate can’t increase more than 2 percentage points, or 2%, higher than the previous rate.
- Lifetime adjustment cap: This cap refers to the total rate increase over the life of the hybrid mortgage. A common lifetime adjustment cap is 5%, so your interest rate can never be more than 5 percentage points higher than the initial interest rate — the fixed rate you started with — on the loan.
Of course, these are common rate caps, but lenders can set their own limits, so it’s important to review what those caps are before signing on the dotted line. You also should compare rate caps among multiple lenders to see how they change over the course of the loan. You may find one lender has lower rate caps than another.
Which loan programs offer hybrid mortgage options?
There are several hybrid ARM loan products available to homebuyers.
Conventional loans
Freddie Mac offers hybrid ARM loans through conventional lenders with 3/1, 5/1, 7/1 and 10/1 loan terms for purchases and refinances on single-family homes, condominiums, second homes, manufactured homes and one- to four-unit primary residences or investment properties. Fannie Mae has 7/1 and 10/1 hybrid ARM loan options available through conventional lenders. With so many options, it’s important to review the rates and caps for each type of conventional hybrid mortgage you consider.
VA
The U.S. Department of Veterans Affairs (VA) backs loans that are available to active-duty military members, veterans and eligible surviving spouses. VA hybrid mortgage loans offer fixed-rate periods of three, five, seven and 10 years. The rate cap for loans with a fixed-rate period of less than five years is 1 percentage point up or down for the initial adjustment, and the lifetime adjustment cap is 5 percentage points. For hybrid mortgage loans of five years or more, the initial adjustment cap is 2 percentage points up or down, and the lifetime adjustment cap is 6 percentage points. For all VA hybrid mortgage loans, the subsequent adjustment cap is 2 percentage points.
FHA
There are four hybrid FHA mortgage loan products backed by the Federal Housing Administration (FHA) with fixed-rate periods of three, five, seven or 10 years. The CMT or LIBOR index may be used to determine the interest rate for an FHA hybrid mortgage. Rate caps vary based on the type of hybrid mortgage you receive. With a three-year hybrid ARM loan, the initial adjustment cap is 1 percentage point, and the lifetime adjustment cap is 5 percentage points. With five-year hybrid ARM loans, the initial adjustment cap can be 1 percentage point with a lifetime adjustment cap of 5 percentage points or an initial adjustment cap of 2 percentage points with a lifetime adjustment cap of 6 percentage points. All seven- and 10-year hybrid mortgages have a 2-percentage-point initial adjustment cap with a lifetime adjustment cap of 6 percentage points.
NOTE: USDA loans are only available with fixed rates, so a hybrid mortgage option isn’t available.
Pros and cons of a hybrid mortgage
Pros
The long, fixed-rate period. A hybrid mortgage could provide a longer introductory fixed interest rate than other ARMs.
Possibly lower starting payments. With a lower introductory interest rate, it’s possible you’ll also enjoy a lower mortgage payment for a while.
Rate caps. With rate caps, you can know your rate won’t skyrocket when it adjusts.
Cons
Risk and uncertainty following fixed-rate period. Although there are rate caps in place, any rate increases could still be a financial burden on your budget.
Payment caps. Because of a payment cap, you may find that you’re paying more on the hybrid mortgage than the original loan amount, which could negate any savings you received during the fixed-rate period.
You may not have funds for other major expenses. If you’re preparing to cover college tuition, pay for a wedding or fund another major life event, you may not have the cash you need if your hybrid mortgage payment increases more than expected after a rate adjustment.
Is a hybrid mortgage right for me?
There are many features of a hybrid mortgage that could benefit you. However, it’s important to review all aspects of your financial situation to make sure it’s the right option.
A hybrid ARM loan makes sense if:
You need a lower payment for a short time.A lower payment could help you build up savings for other expenses or your retirement.
You’ll be paying down your principal for a future loan recast. With a lower interest rate upfront, more of your payment could be applied to the principal, which could make it easier to recast your loan and shrink your monthly payment amount.
You’re expecting a large raise. If you expect a promotion or salary bump before the fixed-rate period ends, a hybrid mortgage could provide a way for you to get a home loan now, knowing you’ll be in a good position to make payments after the fixed-rate period ends.
You’ll be selling the house and moving before the rate adjusts. If you don’t plan to be in the house for the entire fixed-rate period, a hybrid mortgage could be a great option to buy a house at a low interest rate, maximizing your savings.