How a Hybrid Loan Works (and Why This Type of Mortgage Benefits You)

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It's borrowing 101: a low interest rate helps you minimize monthly payments and reduce the overall cost of borrowing. If you’re looking for a way to lower your rate without the risk of a higher mortgage payment next year, a hybrid loan may be the solution.

However, your interest rate and monthly payment could change in as little as three years, so potential borrowers need to understand the pros and cons of these loans.

Basics of Hybrid Loans

Hybrid loans come in various forms, but they are most popular for home loans. They are a “hybrid” (or mixture) of fixed-rate loans and adjustable-rate mortgages (ARMs)—so you get some of the benefits of each type of loan.

The primary benefit of fixed-rate loans is that they are predictable. Your lender will give you a set interest rate that won't change, no matter how long you plan on taking to pay off the debt. That gives you stability when budgeting since you always know what your monthly payments will be. A hybrid loan provides that stability for up to 10 years before the adjustments begin.

Adjustable-rate loans typically start with lower interest rates, which makes them appealing. Those lower rates result in lower monthly payments. However, if interest rates rise (as measured by an index), the interest rate on your loan will rise as well. Higher interest rates will hike your monthly payments, and if you don't have the cash to cover the higher payments, then you could start falling behind on payments.

Hybrid loans are available from conventional lenders. You can also use government programs such as FHA and VA loans to make qualifying easier. Government-backed loans might be best if you plan to make a small down payment or if you have issues in your credit history, but don't ignore conventional loans. As with most major financial decisions, you're best served by shopping around and exploring all your options before making any commitments.

When They Work Best

That lower starting rate comes with some risk, but hybrids can make sense in the right situation.

Short-timer

If you plan to move or refinance within just a few years, you can take advantage of a lower rate and get out of the loan before adjustments begin. This strategy can backfire if plans change and you decide to keep the loan for longer than you originally intended.

Prepayments

You can reduce your risk by making significant additional payments that go well beyond your required monthly payment. If you anticipate having enough income to quickly pay down your loan balance, you may be able to pay off the loan before adjustments kick in. Even if you can't pay it all off before adjustments begin, a significantly lower balance will help offset higher rates.

Falling Rates

If rates move lower, that'll be great for your loan. Not only did you start with a low interest rate, but falling rates could bring that interest rate down even lower. Predicting the future is hard, though, so make a backup plan in case rates rise. You'll also want to pay close attention to the terms of the loan because not all ARMs have interest rates that fall when the index rate does. In fact, some may rise, even if the rate stays steady—often if the loan includes a provision that caps interest movement. Those caps are meant to protect you from sudden spikes in interest rates, but they also reduce the benefit of falling rates.

Poor Credit

If your credit needs a boost, you can benefit from relatively low rates during the early years of a hybrid loan. Your on-time payments should help to improve your credit, but keep in mind that qualifying for a better rate down the road is never guaranteed—especially if rates rise sharply.

How They Work

Hybrid loans start with a rate that is lower than a standard 30-year fixed-rate mortgage, but the rate can change after several years. As mentioned above, lenders may offer caps to how much the interest rate can move in any given year. That gives borrowers some protection if rates rise dramatically, but it also cuts into the benefits of falling interest rates.

Fixed Period

A hybrid ARM typically uses a fixed rate for a period of three, five, seven, or 10 years. During that time, your initial interest rate and monthly payments remain the same. When researching hybrid loans, the first number listed tells you how long the fixed period lasts. Using a 5/1 hybrid mortgage, the rate remains the same for the first five years. A 10/1 hybrid mortgage would keep the initial rate for 10 years.

Adjustment Period

After the fixed period ends, the interest rate can change, and the second number in the name of the loan tells you how often that happens. A 5/1 ARM can adjust every (one) year for the remaining life of the loan.

Monthly Payments

If the interest rate changes, your monthly payment will change. Loan payments are calculated to pay off your debt and cover interest charges over the remaining life of your loan. Higher interest rates require higher monthly payments, and that’s usually an unwelcome surprise for borrowers. Lower rates, on the other hand, can pleasantly surprise borrowers with lower monthly payment requirements.

As an example, let's consider a loan amount of $200,000.

A 30-year fixed-rate mortgage with an interest rate of 4.25% will have a monthly payment of $983.88 (learn how to calculate monthly payments, or use a spreadsheet to do so). The monthly payment will not change.

A 5/1 ARM with an interest rate of 3.4% starts with a monthly payment of $886.96—a savings of $96.92 per month. After five years, the interest rate and monthly payment could increase or decrease.

How Rates Change

Two key factors influence your rate. Your lender starts with an index rate, and then adds a spread. Those key factors can also be influenced by rate caps set by the lender.

Benchmarks and interest rates in the broader economy influence your adjustable rate. All the individual interest rate increases and decreases are lumped together as an index, which makes it easier to gauge broader interest rate trends. Hybrid loans are linked to an index, and this index becomes the starting point for your rate. For example, your loan might use the London Interbank Offered Rate (LIBOR) as an index. As that rate moves up and down, your loan’s rate can move along with it.

Lenders add an amount known as the “spread” or the “margin” to arrive at your final interest rate. This extra interest charge provides additional compensation to lenders. For example, let's assume you have a hybrid loan that is in the adjustment period. The 1-year LIBOR is currently 2%. The spread on your loan is 2.25%. Your loan’s interest rate will adjust to 4.25% (2% index rate plus 2.25% spread).

Most hybrid loans limit or “cap” how much interest rates can change. These caps reduce the risk for borrowers by preventing unlimited rate increases. There are a few different types of caps, so pay close attention to the one offered by your potential lender.

Initial caps limit how much your rate can change on your first adjustment after you finish the fixed period. For example, if the index moves by 3% but you have a 2% initial cap, your rate would only move 2%.

Periodic caps limit how much the rate changes at each adjustment opportunity. For example, the rate might be able to change no more than 2% every year.

Lifetime caps set a maximum limit on the total adjustments over the life of your loan. Rates may rise suddenly in any given year, but if they rise so much that they hit that lifetime cap, rates will not increase any more going forward.