One popular solution is a hybrid mortgage, which has a lower fixed rate for three, five, seven or 10 years, after which the rate expires and the loan adjusts to a potentially much higher rate.
The argument in favor of these loans is often predicated on the assumption that the borrower will move out of the house, refinance the loan or receive a fat pay raise before the fateful day when the rate and payment may rise.
That argument may make sense for borrowers who have a definitive short-term plan to move, refinance or get that raise and also have the financial resources to weather a higher payment if rates rise and such plans don’t work out as, ahem, planned. The benefit is that a hybrid is undoubtedly cheaper over the initial period compared with a 30-year fixed-rate loan.
The trade-off, of course, is that a hybrid mortgage effectively transfers a portion of the interest rate risk from the lender to the borrower. The lender spreads that risk over thousands of mortgages with different rates, time horizons and rate caps, while the borrower is exposed to the risk on just one loan — his or her own mortgage.
Do the math on a hybrid, and it’s clear that an increase of even, say, 3 percent — half of the typical adjustment cap — might make that loan unaffordable to that borrower three, five, seven or 10 years in the future. Add lower house prices, unemployment, disability, a spouse’s death or any of one thousand other calamities, and the loan may end up in foreclosure, and the house could be lost.
A 30-year fixed-rate loan with its play-it-safe, peace-of-mind reputation might seem downright stodgy in comparison with a hip-sounding hybrid. But the safer loan never needs to be refinanced, and it offers the borrower complete protection from the risk of a higher rate and payment in the future.
So, what’s your opinion: Are hybrid mortgages worth the risk?