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What about hybrid loans, those fixed for 3 to 10 years?

Hybrid loans have an interest rate that is fixed for three, five, seven or ten years. These are sometimes referred to by names like ‘five-year fixed’ or ‘7/1 ARM’. They are called hybrid because they combine characteristics of fixed rate mortgages and adjustable rate mortgages (ARMs). At the end of their fixed interest rate period they become ARMs.

Advantages

These loans can provide a substantial saving over a 30-year fixed loan during their initial fixed period because they have a lower interest rate than a 30-year fixed. Generally, the shorter the fixed period the lower the rate and the greater the spread between the hybrid interest rate and the 30-year fixed interest rate.

Why you may choose a hybrid over a fixed-rate loan:

• You believe that you will only be in the property for a short while—3 to 10 years—and want the lower interest rate from the hybrid knowing you will be out of the property before it becomes an ARM
• You understand the cyclical nature of interest rates and believe you will be able to refinance at a lower interest rate before the hybrid converts to an ARM
• You need the lower payment that comes with the lower interest rate of the hybrid

If you are considering a hybrid, always compare the interest rates among different hybrids—a 5-year, a 7-year, and a 10-year—and between the hybrids and the 30-year fixed. This is important because the interest rate varies between different hybrids, and between a given hybrid and a fixed-rate loan, depending on current conditions in the financial markets.

For example, if the difference in interest rate between a 5-year fixed and a 30-year fixed is only one-quarter of a point—less than $100 a month in most circumstances—you may prefer the greater security of the 30-year fixed. However, if the difference is one percent in rate—a payment difference of hundreds of dollars—you might feel that the interest rate risk that you take on with the hybrid is worth the reward from the lower payment.

Also, when you are comparing hybrids, don’t just look at the initial interest rate. If you end up keeping the mortgage longer than you had planned, the adjustable rate loan that your hybrid converts to will be important. Check the index, the margin, and especially the life cap.

Disadvantages

Your risk with these loans is that you may end up staying in the mortgage longer than you had planned, and then are stuck with a hybrid that has converted to an ARM at a high interest rate.

Important considerations:

• If you are fairly certain about how long you will keep your mortgage, your best choice will almost always be the loan whose initial term matches the length of time you think you will have that mortgage. If you’re likely to move in three years, you would opt for a loan fixed for three years; if you know you’ll be starting a family in five or six years and moving to the ‘burbs’, you might opt for a 7-year fixed. A 6-month or 1-year ARM might be the right choice if you know you are going to be refinancing in a year or two when you complete a major remodel.
• The variation between the interest rate on hybrids of different terms, and between hybrid rates and a 30-year fixed, can vary dramatically depending on the markets expectation of future economic activity and inflation. As I write this, December of 2006, the interest rates on a 3-year fixed, a 5-year fixed, a 7-year fixed, and a 10-year fixed are separated by one quarter of a point in rate; the interest rate on a 30-year fixed is only one-quarter point higher than the 10-year fixed. This is because the market expects inflation to be tame and the economy to slow. In a normal market, the spread will be much wider. For example, in 2000, the spread between a 3-year fixed and a 10-year fixed was over one percentage point. This is important; if the difference between the hybrid and the fixed is very small—one-quarter of a point—you may choose to opt for the security of the fixed. If the spread is one or two percentage points, the hybrid may be more attractive, depending on your tolerance for risk and how long you think you will have the loan.

A word of caution

Beware of loans with stunningly low payments that claim to be ‘fixed’ for five or seven years. These are actually negative amortization loans that have a minimum payment—not interest rate—fixed for five years. However, the interest rate can adjust frequently and is usually much higher than the interest rate on a 5-year fixed. You can make the very low minimum payment, but your loan balance will be getting bigger each month. See What about negative amortization loans? for details.