March 29, 2017
It wasn’t all that long ago there appeared to simply be no end to the number of available mortgage programs in the marketplace. Leading up to 2008 borrowers were met with a sometime dizzying array of choices. It seemed everyone offered a loan of some type. It used to be there were two primary choices- a conventional loan underwritten to Fannie Mae or Freddie Mac standards and government-backed loan programs from FHA and VA. Yet as the housing bubble first began to form, the gates were left wide open.
There were stated income loans, no document loans and no down payment loans. Loans for people with bad credit and loans for people without a job. Interest only loans and payment option loans were popular. If someone could fog up a mirror there was probably a mortgage program for them somewhere. Yet we all know what ultimately happened. Lenders began to foreclose on non-performing loans. Toxic loan programs vanished along with the lenders who made them. All that was left standing are the original conventional and government.
Both programs also offer a choice between a hybrid and a fixed. A fixed rate is one where the interest rate never changes while a hybrid loan is an adjustable rate mortgage disguised as a fixed. For example, a 3/1 hybrid is a loan where the rate is fixed for an initial three year term before turning into a loan that can adjust annually. Hybrids also come in various terms such as a 5/1, 7/1 and a 10/1. Perhaps the most popular of the hybrid landscape is the 5/1 mortgage. Why?
If loans only last around seven years on average either because the owners refinance out of the loan or sell the property and paying off the existing mortgage, a 5/1 might be a prudent choice. A hybrid loan has an interest rate that is a bit lower than a fixed rate mortgage. That’s why borrowers select a hybrid in order to get a lower monthly payment. If you can get a better rate, then why not?
A 5/1 hybrid is fixed for five years at a rate lower then prevailing 30 year fixed rates before it turns into an adjustable rate loan. Yet there are consumer protections built into a hybrid that limits how much the loan can adjust each year. These protections, called interest rate caps, limit how much the new rate can be compared to the previous rate. An adjustable rate mortgage is based upon an index, such as a 1-year Treasury Bill and a margin. The two are added together to arrive at the new rate. But what if the T-Bill shot up to say 12% over one year? That’s not going to happen but we’re going to make a point. If the margin were 2.00 and the T-Bill 12% the new interest rate would then be 14%. If the T-Bill were 2.00% then jumped to 12%, that’s quite a payment shock. Interest rate caps would limit the adjustment by either 1.0 or 2.0% at each adjustment period.
Because the 5/1 hybrid starts out lower than a fixed and the first two adjustments are limited by the interest rate caps, that’s still a savings. For long term borrowers who have no intention of moving or refinancing might consider a fixed rate over a hybrid. But for those who think they’ll be moving down the road, the 5/1 deserves some consideration.
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