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

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A low interest rate helps you minimize monthly payments and borrowing costs. 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 a solution. But your interest rate and monthly payment could change in as little as three years, so it’s essential to understand the pros and cons of these loans.

Basics of Hybrid Loans

Hybrid loans come in various forms, and 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.

Fixed-rate loans are predictable: You know what your interest rate will be for the life of your loan, and 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 out with lower interest rates, and lower rates result in a lower monthly payment. However, if interest rates rise, your monthly payments can increase, which is problematic if you don’t have the cash flow to cover higher payments.

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 before adjustments begin. But if plans change and you keep the loan, the strategy can backfire.

Prepayments: You can reduce your risk by making significant additional payments—above and beyond your required monthly payment. If you pay down your loan balance quickly enough, you may be able to offset higher rates and avoid a major payment shock.

Low rates: If rates stay put or move lower, you’ll benefit from that lower starting rate over the long-term. But predicting the future is hard, so make a backup plan in case rates rise.

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. Lenders typically limit how much your rate changes yearly and over the life of the loan, offering some protection if rates rise dramatically.

Example: Assume a loan amount of $200,000.

  • A 30-year fixed-rate mortgage with an interest rate of 4.25 percent 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 percent starts out 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.

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 the 5/1 ARM described above, the rate remains the same for the first five years. A 10/1 hybrid mortgage would keep the initial rate for ten 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. But rates can also fall.

How Do Rates Change?

Two key factors influence your rate. Your lender starts with an index rate, and then adds a spread.

Index: Benchmarks and interest rates in the broader economy influence your adjustable rate. Hybrid loans are linked to an index, which provides a 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.

Spread: 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.

Example: Assume you have a hybrid loan that is in the adjustment period. 1-year LIBOR is currently 2 percent. The spread on your loan is 2.25 percent. Your loan’s interest rate will adjust to 4.25 percent (2 percent plus 2.25 percent).

Rate caps: Most hybrid loans limit or “cap” how much interest rates can change. These caps reduce risk for borrowers by preventing unlimited rate increases.

  • 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 percent but you have a 2 percent initial cap, your rate would only move 2 percent.
  • 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 percent every year.
  • Lifetime caps set a maximum limit on the total adjustments over the life of your loan. If rates rise to hit that cap after just a few adjustments, rates will not increase anymore going forward.

    Hybrid loans are available from conventional lenders, and 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 you have issues in your credit history, but don't ignore convential loans.

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