- Leveling off of home prices around the country are already challenging buyers to either come up with larger cash down payments or stretch to qualify for larger mortgages. Higher interest rates makes qualifying for a mortgage even more difficult.
In the past, the easy solution to rising interest rates would be to switch from fixed rate financing to an adjustable rate mortgage (ARM). But alot of buyers often feel uncomfortable about signing up for a mortgage with monthly payments that can rise over time -- particularly in a rising interest rate environment. A more enticing alternative that provides interest rate security and lower monthly payments is the hybrid mortgage
A Hybrid Mortgage
, also called a fixed-period ARM, combines features of both fixed-rate and adjustable-rate mortgages. A hybrid loan starts out with an interest rate that is fixed for a period of years (usually 3, 5, 7 or 10 years). Then, the loan converts to an ARM. The beauty of a fixed-period ARM is that the initial interest rate for the fixed period of the loan is considerably lower than the rate will be on a mortgage that's fixed for 30 years.
Usually, the shorter the fixed term of the loan, the lower the initial interest rate. But while the savings might be greater in the short-run with a 3-year or 5-year fixed, most buyers prefer the 10-year fixed hybrid mortgage. Recent studies have shown that most homeowners either refinance or sell their home within 5 to 7 years. So most buyers who opt for a 10-year fixed will never experience adjustable-rate payments.
Be aware that many fixed-period ARMs have prepayment penalties. Although prepayment penalties are illegal in some states they are legal in states such as California. The prepayment penalty usually runs for the first three years of the loan. So if your plans were to change and you sold your home within three years of originating the loan, you'd have to pay the lender a penalty fee. If you think there's any chance that you won't be in your home for three years, you could be better off taking an ARM.
Some buyers elect to take balloon payment fixed mortgages. These loans often have lower interest rates than either 30-year fixed-rate loans or fixed-period ARMs. Balloon payment mortgages have a short term of 5, 7 or 10 years. At the end of the term, the remaining unpaid balance on the mortgage is due. This is called a balloon payment. Some balloon payment mortgages have a provision that allows the loan to be extended for one year at an adjustable rate. This provides a safety net if mortgage rates are very high, and refinancing is difficult, when the loan is due. With a balloon payment mortgage, it's wise to plan ahead and refinance early.