What is a hybrid mortgage?

How does a hybrid mortgage work?

The hybrid mortgage has two distinct periods: an introductory fixed-rate period and a subsequent adjustable-rate period.

During the fixed-rate period, the interest rate remains unchanged. This gives borrowers predictable monthly payments. Once the fixed period ends, the rate adjusts regularly based on a market index plus a set percentage from the lender.

Structure of a hybrid mortgage

You’ll often see two numbers that represent a hybrid mortgage. These describe how long the initial fixed-rate period lasts and how frequently the rate will adjust thereafter. In a 5/1 ARM, for example, the rate will be fixed for five years, and then it will adjust every year thereafter.

Fixed and adjustable periods

Borrowers like the fixed-rate period for its certainty and stability. It’s especially helpful for homeowners on tight budgets or buyers who don't plan to stay in the home for more than a few years.

After the fixed term ends, the loan converts to an adjustable-rate mortgage. At this point, the rate can go up or down with the market. This shift adds risk but also creates the chance for lower payments if rates fall.

Common types of hybrid mortgages

Common hybrid mortgage options include:

• 3/1 ARM: The rate is fixed for three years, then adjusts once a year.
• 5/1 ARM: The rate is fixed for five years, then adjusts once a year.
• 7/1 ARM: The rate is fixed for seven years, then adjusts once a year.

These different structures allow you, the borrower, to decide how much time you’ll want in the fixed portion of the loan before jumping into the adjustable rate.

Interest rate adjustments and caps

Once the fixed period ends, hybrid mortgage interest rates adjust based on an index and a margin.

• The index reflects current market rates, such as the Secured Overnight Financing Rate or the Treasury index.
• The margin is a fixed percentage set by the lender.

To get the new rate, you simply add the index and the margin together.

How rate adjustments work

If the index rises, your rate will rise and vice versa. Rather than leaving your rate up to the lender’s discretion, rate adjustments follow this clear formula. You should always review your loan documents to understand exactly how your rate adjustment and caps work.

Interest rate caps

One of the biggest concerns for borrowers with hybrid mortgages is an extreme increase in the market, and therefore the rate. For this reason, hybrid mortgages come with interest rate caps. These spell out how much a rate can change. For example:

• Initial rate cap: This defines how much your rate can increase after the first adjustment.
• Subsequent rate cap: Here, you’ll find the limits on the rate increases at later adjustments.
• Lifetime cap: This gives you a maximum ceiling on how high your rate can ever go.

For example, a 5/1 ARM with a 2/2/5 cap means the rate can’t rise more than 2% at the first adjustment, 2% at each subsequent adjustment and no more than 5% over the life of the loan. So if your fixed rate is 3%, your adjustable rate can never go higher than 8%.

How lenders set the new rate

To set your adjustable rate, your lender will use a combination of the published index and the margin. You’ll find this formula in your loan agreement. This standardized approach helps make sure your loan agreement is transparent. It also helps you anticipate how any future rate changes will affect your monthly payments.

When you’re comparing your mortgage options, be sure to review each lender’s rate caps and margin terms carefully. The smallest differences in the margin can have a huge impact on your long-term costs.

Benefits of hybrid mortgages

Hybrid mortgages come with a ton of advantages, so they can be incredibly attractive to borrowers. These include:

Lower initial interest rates

With a hybrid mortgage, the lender shares the interest rate risk with the borrower. The initial fixed rate is usually much lower than the long-term fixed rate on a traditional mortgage. This translates to lower monthly payments in those earlier years of the loan.

Potential cost savings

If market interest rates drop after the fixed-rate period ends, the borrower will benefit. Your rate will go down, and you won’t have to refinance. In this way, hybrid mortgages can provide a natural hedge against falling market rates.

Increased borrowing power

With lower initial payments, you might qualify for a larger loan than you would on a traditional mortgage. This power is particularly potent if you live in a competitive real estate market. Without a hybrid mortgage, you may have fewer purchasing options.

Flexibility for future plans

Many homebuyers don’t plan to stay in their property for more than five to 10 years. If you’re planning to move or refinance, a hybrid mortgage offers upfront stability. Then, you get the flexibility to move to a new loan or sell the home before you have to deal with the adjustable rate period.

Risks and considerations

Of course, every product has a downside, and hybrid mortgages are no exception. Here are the risks and factors to consider:

Higher payments after the fixed period

Once the loan enters its adjustable-rate phase, your payments can rise dramatically. It all depends on market interest rates. A borrower who locks in a very low rate during the fixed period could face much higher payments later if the market rates increase.

Personal and financial uncertainty

Timing, as they say, is everything. Before choosing a hybrid mortgage, assess your:

• Career trajectory
• Financial stability
• Long-term plans

If you think you might have changes in income, employment or housing needs, a hybrid mortgage can make life much more difficult.

Challenges with refinancing or selling

To minimize long-term risk, many borrowers with hybrid mortgages plan to refinance or sell before the adjustable-rate period begins. Unfortunately, this strategy only works if the market is doing well. You’ll also need enough home equity to qualify for a new loan or make a profit from a sale.

Finally, if your credit score drops, you may not get a better interest rate at all.

» LEARN: What’s the difference between fixed-rate and ARM?

Who benefits from hybrid mortgages?

At this point, you’re probably wondering who specifically should choose a hybrid mortgage. It helps to understand who benefits from this type of loan.

Borrowers seeking upfront stability and future flexibility

If you’re looking for predictable payments in the short term and don’t plan to stay in the home, a hybrid mortgage can be the best of both worlds. The lower initial rate gives you breathing room in the first years. Then, you can refinance or relocate before your payments potentially go up.

Lenders managing interest rate risk

Hybrid mortgages help lenders manage their long-term interest rate exposure. Because they transfer some of the rate risk to the borrower after the fixed period, lenders can potentially increase revenues during the adjustable rate period. This allows them to remain competitive by offering much lower interest rates up front.

Real estate professionals offering diverse options

Real estate agents and mortgage brokers get to add hybrid mortgages to their portfolio of lending options. This helps them stay competitive among their peers because they’re able to better serve clients with diverse financial goals.

This is especially true for those clients who aim to maximize purchase power or take advantage of shorter-term housing plans. When they can offer hybrid loans as well as traditional fixed and adjustable-rate products, real estate professionals can tailor their offerings to specific client needs.

» COMPARE: Top-ranked mortgage lenders

Is a hybrid mortgage right for you?

Most borrowers use hybrid mortgages for lower starting payments and short-term stability. If your timeline is under the fixed period, the trade-off can work. If you need the same payment for the full term, a fixed-rate loan fits better.

Choose a hybrid mortgage if:

• You plan to move or refinance within the fixed period.
• You want lower starting payments.
• You can handle a possible payment increase later.

Skip a hybrid mortgage if:

• You need the same payment for the full term.
• Your budget has no room for increases.
• You are unlikely to qualify to refinance.