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Are hybrids worth the risk?

By Marcie Geffner · Bankrate.com
Tuesday, February 15, 2011
Posted: 12 pm ET

The sharp rise in mortgage interest rates has presented a challenge for borrowers who want to buy a home or refinance an existing mortgage, but don't like the slightly higher payment they now face.

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?

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8 Comments
Gary Stenerson
February 19, 2011 at 11:44 pm

Hybrids is just another way to be creative to hide the true risk and the true interest rate. Banks and borrowers need to do the math. Compute the interest on the initial part of the loan. Set an interest rate for the second portion and compute the interets. Then find the single interest rate that adds up to the total interest rate over the term of both loans. That is the effective interest rate. If you cannot loan money or accept a loan based on the effective interest, then DO NOT DO IT. And don't delude yourself about the law of averages minimizing the risk. If you believe that go to Vegas and loose your money faster then go back to work to make it up.

John
February 17, 2011 at 2:01 am

How do rates compare on hybrid mortgages compared to straight variable or fixed products? Given that products with "bells and whistles" often come at a premium, people might just be better off making a decision and sticking with it.

There is always a fairly significant degree of uncertainty regarding future rate movements, especially over the course of the ever popular 5 year term. Going fixed/variable is as much or more about the amount of risk you can absorb anyway. If you can't take rate shocks, then a fixed is probably for you. If you can, then, IMO, it makes sense to go with the research.

John
February 17, 2011 at 2:00 am

How do rates compare on hybrid mortgages compared to straight variable or fixed products? Given that products with "bells and whistles" often come at a premium, people might just be better off making a decision and sticking with it.

There is always a fairly significant degree of uncertainty regarding future rate movements, especially over the course of the ever popular 5 year term. Going fixed/variable is as much or more about the amount of risk you can absorb anyway. If you can't take rate shocks, then a fixed is probably for you. If you can, then, IMO, it makes sense to go with the research.

C. Burke
February 15, 2011 at 3:32 pm

In Record Low territory, as the interest rates have been for quite some time, the answer is no, IMO. Hybrids may be cheaper in the shorter term, but all economic indicators point to long term rates increasing. The biggest one is that you can't stay in record low territory forever, and inflation WILL come in and cause interest rates to rise eventually. If you're getting a hybrid because you can't afford the 30 year fixed, then you can't afford your home and need to look at something smaller, or selling.