What Is a Hybrid Mortgage?
How it works | How much you'll pay | Is a hybrid mortgage worth it | Compare hybrid mortgages | Summary | FAQs
A hybrid mortgage has a fixed interest rate for a period of time, then adjusts periodically for the remainder of the loan. Essentially, it has features of both a fixed-rate mortgage and an adjustable-rate mortgage.
The draw of a hybrid mortgage is the initial “teaser” rate, which is typically lower than mortgage interest rates for fixed-rate products. Home buyers can start off with a lower interest rate and monthly payment, which could help preserve cash flow.
For example, the rate for a 30-year fixed mortgage could be somewhere around 5% at a given time, whereas a 3-year hybrid mortgage or 3/1 would be around 3% at the very same time. Going with the 3/1 instead of the fixed-rate mortgage could make a considerable difference in the amount of your monthly payment.
How does a hybrid mortgage work?
A hybrid mortgage starts off with a fixed interest rate and then adjusts based on the terms of the loan.
A three-year hybrid mortgage has a fixed-rate for three years (36 months) before converting into an annual adjustable-rate mortgage, meaning your interest rate will adjust once a year for the next 27 years of the mortgage.
In the same way, a five-year hybrid carries a fixed interest rate for five years, then adjusts annuals for the remaining 25 years.
When the fixed interest rate changes to the adjustable rate, this is known as your reset date. You’ll know the reset date based on the kind of hybrid mortgage you have.
Hybrid mortgages are typically expressed as fixed duration / adjustment frequency So a 5/1 is fixed for the first five (5) years and then adjusts every (1) year. |
Depending on your lender, you may have access to a wide variety or just a few hybrid mortgage options. Common hybrid loans include 5/1, 7/1, and 10/1.
Some more exotic hybrid products adjust every six months (e.g., 3/6 ARM) months or just once after 15 years (15/15 ARM).
Know your initial fixed rate
The initial rate will affect your monthly mortgage payment during the fixed-rate period. If this amount doesn’t feel comfortable, it could become less comfortable if your interest rate increases later on.
What affects loan terms?
At the start of your loan, your loan documents will indicate your:
- Exact hybrid mortgage product
- Length of your initial term
- Teaser interest rate
- Reset date (when the new adjusted rate begins)
Your contract will also say how often your interest rate adjusts, based on what factors (such as an index) and limitations. When your interest rate adjusts, it will be the sum of the margin and an index rate.
Index
An index is a benchmark interest rate used to calculate the adjustable interest rate portion of your hybrid loan. The specific loan product and lender will determine the index.
Some common indexes:
- The Federal Cost of Funds (COFI) Index
- Constant Maturity Treasury (CMT) Index
- London Interbank Offer Rate (LIBOR) Index
Margin
The margin is the number of percentage points added to the index to set your interest rate when it adjusts. The amount depends on the lender and loan, and it won't change after closing.
Payment caps
There was a time when adjusting interest rates led to many people defaulting on their mortgages and losing their homes.
Today, there are caps on how much your interest rate can change initially, with each adjustment, and over the life of the loan. These limits are expressed as a x/x/x cap structure.
- Initial adjustment cap: How much the interest rate can increase the first time it adjusts after the fixed-rate period expires; often capped at 2 or 5 percentage points above the initial interest rate
- Subsequent adjustment cap: How much the interest rate can increase in the adjustment periods that follow; often capped at 2 percentage points per adjustment
- Lifetime adjustment cap: How much the interest rate can increase in total
Lenders can also set their own limits for your interest rates, so shop around and compare loan estimates to get the best overall rate for your hybrid mortgage.
Example: 5/2/5 cap structure
Your first adjustment can’t be more than five percentage points more than your initial interest rate.
All subsequent rate increases cannot exceed two percentage points.
Your interest rate can never increase more than five percentage points over the life of the loan.
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Is a hybrid mortgage worth it?
The biggest benefit of a hybrid mortgage is having a lower interest rate. Even temporarily, a lower interest rate could mean hundreds of dollars difference in a monthly mortgage.
The downside of hybrid mortgages is that you could have a much higher monthly payment if your interest rate adjusts up. A higher adjustment, coupled with an unexpected life change (e.g., divorce, job loss, medical emergency), could put you at risk of default.
Your can take out a hybrid mortgage for buying or refinancing most property types, including:
- Single-family homes
- Condominiums
- Second homes
- Manufactured homes
- 1–4 unit residences
- Investment properties
A hybrid loan could be right for you if:
You anticipate having more income soon to cover potentially higher payments, in case your interest rate and monthly mortgage payment increase.
This could be the case with:
- Someone in school who’s fairly certain their income will increase soon, such as a medical student
- A one-salary family about to add another source of income, such as a stay-at-home parent re-entering the workforce
You don’t anticipate staying on your loan for more than five to seven years. In the time before you refinance or move and sell your home, you could be paying a lower monthly rate.
A hybrid loan does NOT make sense if:
You don’t foresee selling or refinancing your home anytime soon. If you plan to stick with your 30-year mortgage for the entire term, you’re better off with a predictable fixed-rate loan.
You think your income could decrease in the foreseeable future. For instance, if you plan to retire soon, an adjusting interest rate could be risky — especially if your monthly payment increases but your income stays fixed.
Which hybrid mortgage should I get?
Like fixed-rate mortgages, hybrid mortgages come in a few different flavors: conventional, FHA-backed, and VA-backed.
- Conventional ARMs are ideal for borrowers with a strong credit profile and larger down payment. Both Freddie Mac and Fannie Mae offer hybrid loans through conventional lenders.
- FHA and VA loans require smaller down payments but have additional fees (mortgage insurance and funding fee, respectively).
Mortgage lender | 3/6 | 5/1 | 7/1 | 10/1 | Down payment requirement* |
|---|---|---|---|---|---|
Fannie Mae-backed conventional | ✅ | ✅ | 5% | ||
Freddie Mac-backed conventional | ✅ | ✅ | ✅ | ✅ | 5% |
Federal Housing Administration | ✅ | ✅ | ✅ | ✅ | 3.5% |
Veterans Affairs | ✅ | ✅ | ✅ | ✅ | N/A |
* Down payment requirements could be higher, depending on your credit score and profile. | |||||
Currently, there are no USDA hybrid mortgage products available.
Summary
- A hybrid mortgage combines useful features of a fixed-rate mortgage and an adjustable-rate mortgage.
- Hybrid mortgages work best for people who expect an increase in income or an exit event (e.g., home sale, refinance) that'll get them out of the mortgage soon.
- You can get a hybrid mortgage with financial institutions that offer home loans like banks, credit unions and mortgage brokers.
FAQs
A hybrid mortgage has a fixed interest rate for a period of time, then adjusts periodically for the remainder of the loan.
Depending on your terms, you’ll get an initial interest rate, often called a “teaser” rate, that will reset periodically for the remainder of the loan. Your interest rate could adjust up or down throughout the life of your loan.
Hybrid mortgages can save some borrowers hundreds of dollars each month with a lower initial interest rate and monthly payment. If you can exit this loan before it resets at increased rates, it could be a viable route to homeownership.
A 5/1 is a type of hybrid mortgage product that has a set interest rate for the first five years of the loan, with an interest rate that adjusts every year for the remaining 25 years of the loan.