Filed at 8:20 p.m. ET, April 13, 2003
NEW YORK (AP) -- Even with 30-year fixed mortgage rates sitting near
40-year lows, some homeowners are trying to squeeze out even more savings.
Lately, there's been growing interest in the ``two-step'' hybrid loan,
a type of mortgage that initially acts like a fixed mortgage, but converts
to an adjustable-rate mortgage, or ARM, in later years.
The advantage is that this kind of loan locks in a low rate early. In a
so-called ``seven-one'' hybrid, for example, someone with this loan locks
in a set interest rate -- generally at a lower rate than a typical 30-year
fixed mortgage -- for seven years.
But that rate may change every year thereafter. Given that rates are so
low, they will almost certainly rise by the time the adjustable rates kick
in. Depending on the length of the mortgage, that could mean some buyers
end up paying more.
Still, demand for these products has surged in the past year as the
spreads between the lower-rate loans and the 30-year mortgage have
widened.
The most popular of these hybrids has been the 5-year loan, lenders
said. Rates for the 5-year are hovering around 5 percent, or 1 percentage
point lower than the rate on the 30-year fixed mortgage.
That small difference in rates can lead to significant savings. As a
general rule the homeowner saves $66 a month for each percentage point of
interest dropped on every $100,000 borrowed. That means that a 5-year
hybrid at 5 percent can save a person with a $300,000 mortgage about
$2,376 the first year.
The unpredictable nature of ARMs make these hybrids best suited for
people who plan to dump the mortgage before the adjustable rate kicks in.
This generally means people who plan to move or refinance at a lower rate.
Borrowers still should pay close attention to the hybrid loan's
conditions. Something could happen to change either a person's plans or
market conditions.
When shopping for a two-step hybrid look for low ``margins'' and
``caps.'' The adjustable rate is determined by a margin cost on top of the
1-year Treasury index or the Fannie
Mae Libor index, used as a base index for setting rates of some
adjustable rate financial instruments.
Keep the margin low and the rate can only rise by so much over the
index. A cap may also be applied by the lender to protect the consumer
against interest rates rising too rapidly.
Margins tend to be set at 225 to 300 basis points, but they have been
lower historically. So if the 1-year Treasury rate rises to 6.5 percent
when the adjustable rate is activated, a loan with a margin of 2.75
percent would cost the homeowner 9.25 percent in interest.
A cap of 2 percent could keep that rate down to 8.5 percent.
When looking at margins, it's important to keep in mind that the Libor
frequently has a higher value than does the Treasury, but that loans tied
to the Libor often have lower margins. Libor loans typically have margin
of about 225 basis points versus about 275 basis points for Treasury ARMs,
according to HSH Associates.
When shopping for caps, know that there are two types: the lifetime cap
and the adjustment-rate cap. People should expect adjustment-rate caps of
around 2 percent and lifetime caps of 5 percent. The lower the better.
If a loan says it has an adjustment, or periodic, cap of 2 percent and
a lifetime cap of 5 percent, this means that the rate can rise no more
than two percentage points over the index rate during an adjustment
period, and no more than five percentage points over the original rate
during the life of the loan.
