Faced with mortgage rates of more than 8 percent, home buyers are rediscovering a type of loan that has been out of favor for most of this decade: short- and intermediate-term mortgages that can cut the fixed rate from half a percentage point to a full point.
Mortgage companies and large investors such as Freddie Mac report that three-year, five-year and seven-year loans--all with optional features converting to 30-year financing--have suddenly begun pulling in rate-sensitive buyers and refinancers. The national financial reporting service HSH Associates, which surveys more than 2,500 lenders, found that last week five-year hybrid loans carried average rates of 7.38 percent nationwide, compared with 30-year conventional mortgage rates averaging 8.01 percent. The same survey found seven-year hybrid loans carrying average rates of 7.45 percent.
Freddie Mac, the biggest national investor in five-year "balloon" fixed-rate mortgages, said rates were about 7.5 percent, an attractive discount from 30-year competitors.
What are short-term hybrid and balloon mortgages, and whom can they help most? What sort of consumer snares do they contain? Here's a quick overview of a potentially valuable resource for buyers and refinancers seeking cheaper money:
At first glance, loans with three- and five-year terms appear a little scary. After all, who wants to have to pay back a home mortgage after just 36 to 60 months? But virtually all of these loan offerings come with term-lengthening features. There are two major categories for borrowers to be aware of. First, hybrid mortgages. They're called hybrids because they represent creative blends of fixed-rate and adjustable-rate loans. A three-year hybrid, sometimes also called a "3-1" or a "3-27," carries a fixed rate for the first three years, then converts into a one-year adjustable for as long as 27 years. A five-year hybrid carries a rate that is fixed for the first five years and then turns into an adjustable for up to 25 years.
The shorter the fixed-rate portion of a hybrid, the steeper the discount off 30-year rates. Hence, a three-year hybrid last week could be found in most markets for about 7 percent, whereas a five-year hybrid was close to 7.4 percent. Both quotes carried roughly one point--1 percent of the loan amount--in origination fees. Paul Skeens, senior loan officer for Carteret Mortgage Corp. in Fort Washington, Md., says he particularly recommends three- and five-year hybrids to clients needing "jumbo" mortgages of more than $240,000, which is beyond the purchase limits of Freddie Mac and Fannie Mae. That's because in the hybrid field, jumbo loans don't necessarily carry higher rates than smaller loans, the way they do in the conventional fixed-rate market.
Skeens says the five-year hybrids "are really excellent choices" in the current rate environment because borrowers not only get a cut-rate loan but have the opportunity to refinance any time in the next five years without penalty, before the loan converts into a one-year adjustable.
There are some notable downsides to hybrids as well. For starters, when they convert to adjustable, they subject the borrower to the potentially chill winds of rates far higher than 7 percent or 7.5 percent. If inflation reared its ugly head and short-term rates hit the levels of the early 1980s, you could be paying as high as 13 percent on the hybrid mortgage you signed up for at 7 percent.
That's not likely, but it's possible. And that's why hybrids are best for people who expect either to move or refinance within the fixed-rate time period of the loan--typically five or seven years. They get all the benefits of a discounted fixed rate, but none of the worries of a one-year adjustable.
What about "balloons"? They, too, carry five- or seven-year terms with rate discounts. But unlike hybrids, they carry a definite termination date with an optional, one-time-only rate "reset." Say you take out a five-year balloon in September at 7.5 percent. Sixty months from closing you'll have the option of either paying off the note by refinancing into a new loan, or going for a reset rate--determined by the lender--that would remain fixed for up to 25 years.
If rates have fallen below 7.5 percent, you can reset for 7 percent or 6.5 percent or whatever the lender's current reset rate is. Unlike a refinancing, there would be virtually no transaction or closing costs to reset the rate. Or if rates have risen during the five years, you can compare the reset rate with prevailing market rates and decide whether to pay off the balloon or continue.
The bottom line here: Check out shorter-term loan options if you're looking for a discounted fixed rate. But make sure your loan officer or adviser discusses all the potential downside scenarios of whatever you choose.