Hybrid Mortgages: A Solution to Rising Mortgage Interest Rates

Healthcare Financial Management, May, 2000 by William G. Kistner

Traditionally, home buyers have opted for a standard 30-year fixed-rate mortgage to minimize monthly payments and eliminate uncertainty about fluctuating interest rates. Alternatively, the one-year adjustable-rate mortgage (ARM) has been attractive to prospective homeowners who want the lowest possible initial interest rate and either think rates will stay low for the foreseeable future or do not expect to stay in their home very long. ARMs, however, expose buyers to the risk that rising interest rates will cause a quick increase in mortgage payments.

Rising interest rates may lead home buyers to seriously consider a fixed-period adjustable loan. This hybrid loan promises a fixed interest rate for a specified period, usually three, five, seven, or 10 years. After the fixed-rate period ends, the interest rate typically is adjusted every year. In exchange for risking an increase in rates at the end of the fixed period, the borrower is rewarded with an initial interest rate that is somewhat lower than rates on comparable 30-year fixed-rate mortgages, but higher than a one-year ARM would have.

The rate break could save buyers thousands of dollars initially. The savings would become permanent if the home buyer sells or refinances before the fixed-rate period is over, or if interest rates remain steady or drop after the fixed period ends. Studies show that most people with new mortgages sell or refinance within five to seven years of getting the mortgage.

For a hybrid loan with an initial rate of 7.625 percent fixed for 60 months, the loan rate would be adjusted thereafter every 12 months to the lowest of three options: the then-current rate on one-year Treasury bills plus 2.75 percent, the previous rate plus a maximum annual cap of 2.0 percent, or a lifetime cap of 12.625 percent. There is no prepayment penalty for this loan. In addition, the buyer does not pay any points, but rather receives a $250 credit.

Exhibit 1 shows the payment schedule for the first 10 years of a $100,000 hybrid loan. By way of comparison, Exhibit 2 (page 98) shows the payment schedule for the first 10 years of a $100,000, 30-year, fixed-rate mortgage with the monthly payment fixed at $734. Over the first five years, the hybrid mortgage borrower will pay $1,894 less in interest than the 30-year fixed-rate mortgage borrower. Over the 10-year period, based on the above interest-rate projections, interest payments would swing in favor of the 30-year, fixed-rate loan, but only by $245. This interest amount would be balanced by the $250 credit received when the hybrid loan was taken out.

A hybrid mortgage might be a good option for home buyers who expect to sell their home within seven years or expect another significant drop in interest rates to occur during that period (thereby offering an opportunity to refinance and lock in an attractive rate for the desired term). It is important to understand that the type of predictions that are made in the above example might not materialize.

Future estimates of variable rates are based on historical data but are not guaranteed. Therefore, a borrower must keep in mind that the actual rates after the five-year, fixed-rate period is up could be higher than the estimates, thus potentially negating any short-term advantage the longer the mortgage is held. But, with rates rising, mortgages with an adjustable-rate feature have become of greater interest to prospective home buyers.

William G. Kistner, MM, CPA, is a tax partner, Ernst & Young LLP, Chicago, Illinois, and a member of HFMA's First Illinois Chapter.

                     RATE AND PAYMENT FORECAST FOR A
               $100,000 FIVE-YEAR FIXED/ADJUSTABLE MORTGAGE
                              (10 YEARS) [*]
  Year   Forecast Rate Monthly Payment Yearly Interest
   1        7.625%          $708            $7,594
   2        7.625%          $708            $7,523
   3        7.625%          $708            $7,446
   4        7.625%          $708            $7,364
   5        7.625%          $708            $7,274
Subtotal                  $3,540           $37,201
   6        8.440%          $759            $7,951

   7        8.450%          $760            $7,859
   8        8.510%          $763            $7,805
   9        8.530%          $764            $7,703
   10       8.540%          $760            $7,501
 Total                    $7,346           $76,020
(*.)Long-term interest rate estimates projected
by lender are not guaranteed.
              RATE AND PAYMENT FORECAST FOR A $100,000 30-YEAR
                     FIXED-RATE MORTGAGE (10 YEARS) [*]
  Year   Forecast Rate Monthly Payment Yearly Interest
   1        8.000%          $734           $7,970
   2        8.000%          $734           $7,900
   3        8.000%          $734           $7,825
   4        8.000%          $734           $7,744
   5        8.000%          $734           $7,656
Subtotal                  $3,670          $39,095
   6        8.000%          $734           $7,561
   7        8.000%          $734           $7,457
   8        8.000%          $734           $7,345
   9        8.000%          $734           $7,224
   10       8.000%          $734           $7,093
 Total                    $7,340          $75,775
(*.)Long-term interest rate estimates projected
by lender are not guaranteed.