You would probably associate the word “hybrid” more with machines and cultivation. But with how trendy the financial market has become these days, the word has also been adopted by lenders to label their products. Surely a hybrid mortgage is a better name than a mixed loan or somewhere-in-between mortgage.
Don’t be misled a hybrid mortgage has nothing to do with the matrix or automobiles. It basically refers to a loan with both elements of fixed rates and adjustable rates. When we apply a definition as broad as this, it can basically refer to any type of home loan which is not 100% fixed or 100% adjustable.
The typical structure of a hybrid loan is an initial period of fixed rate between 2 to 10 years. After which, it converts to an adjustable interest pegged to an index plus a spread. The terms of rate refreshing depend from bank to bank and contract to contract. Your adjustable interest could be refreshed to the latest index on a monthly basis, 3 monthly basis, yearly basis, and so on.
Seeing how confusing it might be for some homeowners, the question many would ask is – Why take up a hybrid mortgage in the first place? Why not just go with fully fixed or adjustable?
Other than being stubbornly indecisive, there is a logical reason for consumers to choose this types of loans. The primary one is that the borrower has a long term vision of what is going to happen to the economy. He foresees high short term interest rates and low medium to long term interest rates.
Thus, by locking into a fixed rate in the short term, the borrower is protected from interest rate hikes. While in the long term when interest rates decrease, the borrower will benefit from downward pressure on floating rates. It does make sense if we put it this way. The challenge will then be to predict the market with a high level of certainty and specificity.
Compared to a true fixed rate loan, the fixed interest period of a hybrid loan will be lower. This can be advantageous to homeowners or real estate flippers who intend to sell off the house within a few years of purchasing it. This way they benefit from low fixed rates throughout the time frame in which they are servicing the mortgage. The fixed repayments will also allow them to work out their family or operating budgets in more detail.
The risks of higher interest rates is delayed till the time adjustable rates kick in. This allows more time for the borrower to find avenues to increase his income, stockpile his savings, or make lump sum payments towards the principle. As you can see, there can be cash flow and savings benefits.
Many types of hybrid loans made available be lenders are assumable. This means that should you sell the house, the new owner might not have to get his own mortgage approved to buy your house. He can just takeover your existing loan.
Compared to a full adjustable rate mortgage, a hybrid loan will definitely have a higher interest during the initial years of fixed rates. It is just the way the market works. Fixed rates are always higher than floating rates during the initial years of a loan. This is to compensate for higher risks. But as time goes by, as markets become less and less predictable, it’s hard to say whether you will eventually be making a good or bad decision with a hybrid.
Should economic conditions rise and general interest rates become very high, you could be in for a shock when adjustable rates come into play. This is why you should review your loans each year. And when the period of fixed interest is going to expire, star shopping around for better home loans to refinance to. You might just realize that you could save a fortune by moving to another lender.
Factors to consider
Fixed interest – Is it lower for your hybrid loan compared to a true fixed rate mortgage?
Closing cost – Even if you are getting a good deal for a cheap loan, it might not be in your favor should there be high costs and fees involved to close.
Type of index – A common index is the LIBOR. It moves along with a performing market. If you are not comfortable with that, switch to a more conservative index.
Margin – Also called the spread, this varies from lender to lender. You will only be able to find out where the lowest margins are when you shop around or have the help of an ethical broker.
Redemption penalty – Also called the prepayment penalty, this refers to the penalty charges you have to pay when you pay off the loan before it fully runs it’s course. If you fully intend on making an early full repayment, this could be an important point to take note of. Because whatever interest saving you might have made could be wiped out from a high penalty fee.
Caps – Also called a ceiling, this is a set limit which your interest rate can rise. For example, if your cap is 3%, that is the maximum that you will pay even if interest has risen to 5% in the market. There are typically 3 types of caps. Lifetime, adjustment, and payment. Common sense will tell you that the more caps you have and the lower they are, the better off you will be. But you won’t be able to find one that meets all those criteria. It often has to balance out between each other.
You might want to take a look at historical rates to determine how high you really think mortgage rates can rise in future. This is so that you can look for a cap within a comfortable range. And remember that you don’t have to stick to a lousy mortgage if you hate it. There will always be an option to refinance. Ignoring this option is akin to flushing your money down the toilet.