Hybrid Mortgages Offer
The Best of Two Worlds

Jan. 15, 2002 -- Worried that you missed the boat by not refinancing your mortgage before rates started rising?

You might want to consider a hybrid.

Hybrid adjustable rate mortgages -- which resemble fixed-rate mortgages in their early years -- could be a particularly good deal right now. Take the "five-one" hybrid, which offers a fixed rate for the first five years and then adjusts annually for the next 25 years. As of Jan. 10, the average rate on a five-one is 6.46%, according to HSH Associates, financial publishers in Butler, N.J. That is well below the current 7.33% average for 30-year fixed-rate mortgages.

Hybrids allow borrowers "to still get rock-bottom rates," says mortgage banker Doug Perry, a first vice president with Countrywide Homes Loans, a unit of Countrywide Credit Industries Inc. of Calabasas, Calif. "Consumer interest in these products has increased 50% to 65% in the last couple of weeks."

Because rates can adjust drastically once the fixed term expires, hybrids aren't for everyone. If interest rates soar, someone with a 6.5% hybrid could quickly wind up with an 11.5% mortgage and a vastly higher monthly payment. That makes hybrids riskier than standard 15-year and 30-year fixed-rate mortgages and a bad idea for people on tight budgets who are planning to be in their homes for a while.

But hybrids make sense for people who expect to sell their homes or to pay off their mortgage within a few years. A hybrid allows them to get the lower rates of an adjustable-rate mortgage without taking on the higher risks.

"You can essentially have your cake and eat it, too," says Greg McBride, a financial analyst with Bankrate.com, a consumer-finance Web site in North Palm Beach, Fla. "You get a lower rate than a traditional fixed-rate mortgage, but if you're only going to be in the home for a limited period of time ... you essentially get a fixed-rate loan."

Jess Starkey, the semiretired owner of a manufacturing company, traded his 15-year, 7 5/8% fixed-rate loan for a hybrid that carries a 6% rate for five years when he refinanced his $125,000 mortgage in December. "I'll probably be paying it off in three or four years," explains 64-year-old Mr. Starkey of Surprise, Ariz.

Hybrids have become a better deal over recent months. That is because rates on 30-year mortgages tend to move in tandem with the rates on 10-year Treasurys, which began climbing rapidly in November. Five-one hybrids, on the other hand, generally track one-year Treasurys, which have climbed less.

The bottom line: In December 2000, before the Federal Reserve Board began slashing rates, homeowners could trim their mortgage rate by a mere 0.21 percentage point by choosing a five-one hybrid instead of a 30-year fixed-rate mortgage, according to HSH. Today, the difference is 0.87 percentage point, more than four times more. "That's very high relative to historical measures," says Steve Majerus, a senior vice president with E-Loan Inc., an online lender based in Dublin, Calif.

The savings can be significant. At today's 7.33% rate, a borrower could expect to pay $1,375 a month on a $200,000 30-year fixed-rate mortgage. But with a five-one hybrid at 6.46%, those loan payments would drop to $1,259. Over five years, the hybrid would cut interest charges by nearly $9,000.

Those kinds of benefits were enough to persuade Tim Bradley, a software developer in Seattle, to give adjustables a second look. "When we moved into our house, I didn't want to get one," says Mr. Bradley, who was two and a half years into a 30-year loan when he refinanced his $174,000 mortgage in December. "I worried I would be saddled with a bad interest rate." But after shopping around, Mr. Bradley concluded his best bet was an adjustable-rate mortgage that carried a 5.5% rate for the first five years. "I'm pretty sure we're not going to be in our house more than five years," he says.

Homeowners need to pay close attention to the adjustment terms, even if they expect to hold the loan for just a few years. "You're not supposed to be taking these things if you plan on being there for the long haul," says Keith Gumbinger, a mortgage analyst at HSH. "But if you're there longer than you expect, you want to make sure you have some protections." Rates on hybrids are typically set at between two and three points above a standard measure, such as the rate on one-year Treasurys. Another popular base rate is Libor, the London Interbank Offered Rate, which is what banks charge each other for short-term funding.

Lenders typically limit the amount the rate can rise both during the first year and over the life of the loan. Bank of America Corp., for instance, sets a five-percentage-point cap on both the first adjustment and the lifetime increase. "If it starts out at 7%, then the cap is 12%," explains Robert DeBenedet, Bank of America senior vice president.

But the terms can vary by lender, and, in some cases, by product. Countrywide, for example, sets a six-percentage-point lifetime cap on its three-year hybrids, which means a 7% loan could wind up carrying a 13% rate. But no matter how much rates rise, homeowners will only see their rate go up by as much as two percentage points the first adjustment period.

Rates on Countrywide's five-year hybrids, on the other hand, can increase by as much as two percentage points during the first adjustment period and a maximum of five percentage points over the life of the loan. Rates on its seven-year and 10-year hybrids can increase the full five percentage points during the first adjustment period. "When you talk about a seven- or 10-year loan, the first adjustment is much further down the road," explains Mr. Perry of Countrywide.

Even with the caps, holding a hybrid can be extremely painful if rates rise and borrowers don't move or pay off their loan as soon as planned. Consider a 6.46% hybrid $200,000 mortgage carrying a monthly payment of $1,259. If that mortgage adjusts upward by two percentage points in the sixth year, the monthly payment would increase to $1,502, according to HSH. If the rate climbed by five percentage points, the monthly payment would jump to $1,897, a hefty 51% increase from the original payment.

What happens if rates go down? For the first three to 10 years, while the hybrid carries a fixed rate, your loan rate won't change. After that, your rates can adjust downward, generally subject to the same annual limits that govern upward movements.

With today's rates still low by traditional standards, a big decrease is unlikely. And if rates do plunge, it might be smart to ditch your hybrid and switch to a fixed-rate mortgage that would lock in the low rates.

Email your comments to rjeditor@dowjones.com.