The definition of a hybrid loan is a combination of a fixed-rate loan and an adjustable-rate mortgage. The interest rate is fixed for a predetermined number of years before turning into a one-year ARM for the remaining life of the loan.
Hybrids have a lower starting rate than a fixed-rate mortgage but a slightly higher rate than a one-year adjustable-rate mortgage. The trade-off is the rate guarantee for the first few years. Most hybrid mortgages are fixed for three or five years.
For example, a three-year hybrid mortgage has a fixed-rate for three years (36 months) before converting into an annual (one-year) adjustable-rate mortgage. A 3-year hybrid mortgage is also called a 3/1 ARM. In the same way, a 5/1 hybrid carries a fixed interest rate for five years before becoming a one-year adjustable-rate mortgage.
The hybrid loans have become very popular with home buyers who are not likely to own a home beyond three, four, or five years. In these cases hybrids are hard to beat due to the lower initial interest rate. Hybrid loans are an excellent choice for the transferee.
Are hybrids the best choice?
If you know that you are only going to live in the home for the fixed term of the hybrid loan, then yes, it's a good choice. Another reason to choose a hybrid is if you are certain that you are going to pay off the loan within the 3 or 5-year term.
What happens after the 3 or 5 years?
The new interest rate is based on the lower of either a predetermined adjustment (i.e. 2%), plus the previous interest rate or a convoluted formula that averages the interest rate of treasury bills or some other index.
The lender's margin (profit) is added to the index average. In short, the interest rate cannot exceed the predetermined adjustment, usually 2% or the interest rate could decrease if the index calculation is lower than the previous interest rate. Hybrid loans are a good choice when interest rates are high.
Some lenders have a fixed-rate conversion option after the initial fixed-rate loan term. A conversion option can eliminate the need to refinance the loan to a fixed-term mortgage.
Hybrid loans can help you buy a house
If you're right at the debt to income limit with a fixed-rate mortgage and need a lower interest rate to purchase a great house, and you're sure you can handle a worse case loan adjustment, then the hybrid loan can be the right choice.
But, if you cannot handle a 2% rate increase in 3, 5 or 7 years, then no, a hybrid loan is not for you.
Ask your lender to give you payment estimates with the capped interest rate.