When embarking on a mission to find the best mortgage, even seasoned home buyers can be surprised at the number of choices that must be made. There are conventional and government-backed loans. Conventional loans are those approved using Fannie Mae and Freddie Mac guidelines. Lenders approve loans using these standards and will then have the ability to sell those loans to others such as other lenders or directly to Fannie or Freddie. When a conventional loan goes into default it’s the lender that will take the hit. Government-backed loans are so-called because there is a guarantee to the lender in the instance of default. These loans are FHA, VA and USDA programs. Once the loan type is selected then the borrowers must choose which loan term best suits their needs. The longer the loan term the lower the monthly payment. Shorter loan terms have higher monthly payments but there is less interest paid to the lender.
Another choice to be made is between a fixed and an adjustable. A fixed rate is fairly straightforward. The borrowers select the term of the loan and the rate never changes. An adjustable rate loan as the name implies can adjust based upon the terms written into the note. For example, a one-year adjustable rate mortgage, or ARM, can adjust once per year. The adjustment is based upon an index, such as a 1-year Treasury. When it’s time for the loan to adjust, the lender looks up the 1-year Treasury and adds a margin. A typical margin is 2.00. So, if the 1-year Treasury is 1.00%, the new rate would be 1.00 + 2.00 + 3.00% and will remain there until the next adjustment the following year. ARMs also have rate caps that limit how much the newly adjusted rate can be. The advantage of an ARM is the lower start rate. ARMs can have “teaser” rates that are a bit below market and well below a corresponding fixed rate. ARMs can be a good choice for someone that does not plan to own the home for very long or believes interest rates in general will be lower in the future and wants to take advantage of falling rates resulting in a lower mortgage payment.
But with an ARM, there is also more risk. ARMs can go up and they can go down and in a low interest rate environment where we are today, the likelihood of rates falling is very low. Over time, an ARM can be as high as 5.00 or 6.00% higher than the start rate. If a 1-year Treasury ARM started at 3.00% with a 5.00% cap, it’s possible a rate could reach 8.00%, much higher than prevailing fixed rate loans.
But there is an in-between option called a hybrid. A hybrid is in fact an adjustable rate loan but is fixed for an initial period before turning into a loan that can adjust once or twice per year, depending upon the terms written into the note. A typical fixed rate term can be three or five years. A 3/1 hybrid is an adjustable rate mortgage that is fixed for three years before turning into an ARM that can adjust once per year. A 3/6 hybrid is fixed for three years before turning into an ARM that can adjust once every six months.
A hybrid will have a slightly lower rate than a corresponding fixed but will be a bit higher than a 1-year adjustable rate loan. It’s in between the two and can be a good choice for someone who anticipates keeping the mortgage for say three to five years. When choosing between a fixed or an adjustable, there really is a third choice…the hybrid.