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Chapter 10. Hybrid Mortgages

┠What is a hybrid mortgage?

┠What are the advantages of a hybrid mortgage?

┠What are the disadvantages of a hybrid mortgage?

┠What factors do I need to consider before deciding whether or not to get a hybrid mortgage?

┠Were the 2007-08 housing problems caused by hybrids?

What is a hybrid mortgage?

Hybrid mortgages fall between a fixed rate and an adjustable rate loan. Lenders realized that there was a market for borrowers who wanted the lower cost of an adjustable loan but were afraid of a possible interest rate increase within a short time. The lenders also realized that some interest rate adjustment was better than none at all.

The hybrid mortgage loan begins with a fixed rate for a set time. The most common fixed periods are three, five, seven, and ten years. At the end of the fixed term, the loan adjusts to the agreed-upon index rate plus the margin. Further adjustment is most commonly annually, although the adjustment period may be every three, or even every five, years. The loans are categorized by their overall term, then fixed term, then adjustment period. A thirty-year loan with a three-year fixed term and a one-year adjustment period would be expressed as a 30/3/1 loan. A fifteen-year loan with a five- year fixed term and an adjustment period every three years would be expressed as a 15/5/3 loan.

At the end of the fixed interest period, the loan is recalculated to reflect the new interest rate. If you borrowed $100,000 on a 30/3/1 loan, for example, the loan would be recalculated at the end of three years. Your payment would be based on the new interest rate (index rate plus margin), term remaining (twenty-seven years), and the principal balance ($100,000, less the amount of principal paid during the first three years). Each succeeding year would have an interest rate adjustment based on a change in the index rate, with a resulting payment adjustment.

What are the advantages of a hybrid mortgage?

• The fixed interest rate period is at a lower rate than a fixed rate loan for the entire term. If you expect to sell your home during the fixed rate period, it equates to getting a fixed rate loan at a lower rate.

• The risk of a higher rate is postponed for three to ten years rather than three months to one year with a standard adjustable rate mortgage. This gives you time to increase your income or savings should the new rate require a substantially higher payment.

• Many hybrid loans are assumable, which may be an advantage if you sell the property.

What are the disadvantages of a hybrid mortgage?

• The initial interest rate on a hybrid loan is higher than on an adjustable rate loan.

• The new rate at the end of the fixed rate period may cause a significant increase in the monthly payment.

• Once the interest rate begins to adjust, it could be more costly than a fixed rate loan would have been.

What factors do I need to consider before deciding whether or not to get a hybrid mortgage?

As with most mortgage loans, there are several factors to consider.

Interest rate. Is the lower rate for the hybrid enough to make it worthwhile compared to a fixed rate loan? If you plan to stay in the home for the foreseeable future, you may want to compare the hybrid to a shorter-term fixed rate loan that has a lower interest rate.

Loan costs. A lower interest rate does little good if you are being charged points and other fees that eat up the savings.

Comparing several lenders' programs will help you determine the standard costs.

Index. As you know from Chapter 9, there are leading and lagging indexes. If you are concerned about rate increases, find a lender using a lagging index, such as COFI.

Margin. The lender's profit will be the fixed part of your interest rate once the loan adjusts. Margins can range from .5% to 4% or higher. Get several quotes from lenders. There may be substantial differences in margin amounts, which can also be negotiated.

Prepayment penalty. If you plan to pay off the loan before adjustment begins, a prepayment penalty may eliminate any savings from a lower interest rate.

Caps. There are three caps to protect you from fast-rising interest rates.

1. First is the lifetime cap. A 5% loan with a 5% lifetime cap means that you will never pay more than 10% interest.

2. Second is the interest rate adjustment cap. How much can the rate adjust during any one adjustment period? This is extremely important. It is your security that you can count on a maximum that the rate can adjust and plan for this increase in a rising interest rate market.

3. The third cap is the payment cap. Will any interest rate adjustment be fully reflected in your monthly payment? If the answer is yes, you should figure out what your monthly payment will be if the interest rate adjusts to the highest rate allowed. If the answer is no, will you be able to extend the term of your loan or will you have a balloon payment?

Finally, you must look at the worst possible adjustment. For example, your fixed rate is 5% for three years. There is a 5% cap. The worst that could happen is that three years from now, your interest rate will be 10%. If you owe $240,000 when the loan becomes adjustable, that is a $12,000 per year increase in interest. Will your payment increase by $1,000 per month?

Refinancing will not be a good option, since prevailing rates for a new loan will be in the same 10% range. Since fast-rising interest rates usually drive down property values, you may not be able to get out from under your mortgage by selling your home.

From the Expert

If you feel that you are being overcharged, do not hesitate to tell your lender or mortgage broker that you believe you should get a better margin rate. Ask for an explanation as to why the rate is so high.

Of course, you can what if yourself out of buying a home. If the only way you can qualify for any home is through a hybrid, the gamble is probably worth it. If the hybrid is the only way to buy your dream home, maybe you should look again at the lower- priced adequate home that you could keep if the worst happens to interest rates.

You can plan to minimize a larger increase in interest rates, but the problem is it requires discipline that most people do not have.

If you can take the amount of money you save every month with your lower-interest hybrid loan and put it into some sort of interest- bearing account, you can create a cushion for yourself for when the loan switches from fixed to adjustable.

Example: By getting the hybrid at a lower interest rate, you save $100 per month over a fixed rate mortgage. Your loan will begin to adjust after five years. Each month, you put this $100 savings into an interest-bearing account. At the end of five years, you will have $6,000, plus the amount of interest you have accumulated. This can be used to pay the monthly increase in your payment or give you some time to find a buyer if you cannot afford the higher payment.

The higher your loan, the greater the savings. On a $200,000 loan, a 1% difference in interest would save you $2,000 per year. You would have $10,000 at the end of five years, plus the interest you made on the savings. It may put a strain on your budget, but it might also avoid disaster if the worst happens. Of course, if interest rates do not increase, having an extra $10,000 in the bank cannot hurt.

Were the 2007-08 housing problems caused by hybrids?

Much has been written about the subprime mortgage (see Chapter 23), but the hybrid mortgage is the real problem. Borrowers signed up for hybrid loans that adjusted to high margin loans after a few years. The payment adjustment was too much for the borrowers to be able to pay. This is true of many borrowers with good credit histories as well as the subprime borrowers (those with poor credit histories).

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