Frank and Amy Ortner nervously watched mortgage rates climb for five months as they prepared to buy their first home.
During that time, rates rose a full percentage point, pushing the loan they planned to take out--one with no broker fees or other costs--to about 8%. "We were checking the Internet every day," said Frank, a 29-year-old accountant and financial planner in Phoenixville, Penn.
Rather than accept a higher fixed rate, the couple chose a no-fee, $168,000 "hybrid" loan with a 7.38% rate for seven years and an annually adjustable rate thereafter. That means a monthly payment for the next seven years of $1,160, or $72 less than the 8% loan.
Hybrid mortgages, with a fixed rate for a specified time and an adjustable rate thereafter, are winning favor as rates soar for the most common type of home loan, the 30-year fixed-rate mortgage. Home buyers who missed the chance to borrow when fixed-rate mortgages touched a three-decade low of about 6.5% last year are finding hybrids with lower rates than new fixed-rate loans at 7.75% or higher.
Many borrowers are willing to assume the risk of a higher interest rate in the future because they expect to move to a new home or refinance before the end of the fixed-rate period.
Adjustable-rate mortgages account for more than 16% of all new loans made today, almost twice last year's figure, said David Lereah, chief economist of the Mortgage Bankers Assn. of America in Washington. Hybrids accounted for most of the increase.
Lenders who saw their volume drop in recent months are resorting to low-rate promotions and other gimmicks to lure prospective borrowers. That's a change from October, when rates below 7% attracted crowds of homeowners seeking to refinance with standard 30-year fixed-rate loans.
"Creative salesmanship is becoming important again for loan originators," said Jess Lederman, head of Cleveland-based Ohio Savings Bank's mortgage unit.
In general, the shorter the fixed-rate period on a hybrid loan, the lower the interest rate. Hybrids are available today with a five-year fixed rate at 7.13%, a three-year rate of 6.88% and a one-year at 6.25%.
When hybrids convert to an adjustable loan, the interest rate changes annually to about 2.87 percentage points above the yield on one-year Treasury bills. With one-year Treasuries at 5.05%, that floating rate would be about 7.92%, or roughly the same as today's rate for a 30-year fixed rate loan.
Even those who are stuck with a higher rate when their hybrid loan converts to an adjustable rate may not have made a bad choice. Depending on how high rates go in the future, it could take several years of paying higher rates to wipe out the savings reaped during the fixed-rate period of a hybrid's life, said Barry Habib, president of Certified Mortgage Associates, a Marlboro, N.J., loan broker.
In the worst case for an adjustable-rate borrower, interest rate increases usually are limited to 2 percentage points a year or 6 percentage points over the life of the loan.
Adjustable-rate mortgages, including hybrids, were all the rage in 1993 and 1994, when their rates hovered 3 percentage points below fixed mortgage rates. Last year, rates on three- and five-year hybrid loans were almost as high as 30-year fixed mortgages, and even one-year ARMs averaged just 0.90 percentage point of savings.
Today, three-year hybrid loan rates are about .87 percentage point below fixed-rate mortgages, with a 1.50 percentage point savings for one-year hybrid loans.
That gap is enough for home buyers to take notice.
"Nobody cared about ARMs last year," said Lederman at Ohio Savings. Now, with banks and other lenders making more of the loans, he said loans Ohio Savings buys from others are evenly split between fixed and adjustable rates. Last year, 95% of the loans it bought were fixed-rate.
Washington Mutual Inc. in Seattle is offering an even lower initial rate for borrowers looking to defer higher monthly loan payments as long as possible. Its "option ARMs" allow home buyers to pay as little as 2.95% for the first year. After that, borrowers pay 2.25 percentage points over a Treasury-bill index, which would currently add up to about 7.08%.
The 2.95% rate isn't quite the bargain it might seem. The cash difference between that rate and 7.08% during the first year is added to the loan balance, so when the higher rate starts, interest is owed on a larger loan.
"Many borrowers choose to pay the minimum payments and then use the extra cash to pay down higher-rate debts," said Brad Blackwell, a senior vice president at Washington Mutual.
Option ARMs also offer a provision that prevents the homeowner's minimum monthly payment from increasing more than 7.5%, in dollar terms, in any given year.
The risk of a higher borrowing cost isn't a big concern for Joe Russo, who spends his workdays tracking interest rate fluctuations as the chief money market securities trader for Argentaria in New York. The 31-year-old Russo closed last week on a new hybrid loan with a 5.88% rate for three years. He locked in the rate two months ago.
"We've been in our home 2 1/2 years, and I've refinanced three times," said Russo, who lives in a four-bedroom Colonial in Holmdel, N.J., with his wife, Alma, and three sons. The refinancing will trim Russo's monthly payments by almost $100. "That's extra money to invest in the stock market," he said.