If you never see yourself living in the same house for 30 or more years, why would you ever take out a 30-year fixed rate mortgage? What you need is a short-term mortgage that more closely reflects the actual time you and your family anticipate living in your home.
“Most first-time buyers put their houses up for sale when one of two things happen,” said Marty Rodriguez, a Century 21 real estate agent in Glendora, Calif. “Either the family income rises prompting a move-up or the family simply outgrows the house. Usually, these life-stage events occur within a 10-year time-frame.”
Although many real estate agents will tell you people change homes even earlier — every seven years on average — the National Association of Home Builders (NAHB) reported last year that first home buyers are expected to stay in a home about 11.5 years.
Whether you put more stock in the anecdotal evidence or the NAHB’s recent data, homeowners are clearly not staying in their homes anywhere near 30 years.
Fortunately, there are several short-term fixed-rate adjustable mortgages (ARMs), or hybrid mortgages, on the market more suited to our modern-day mobility and moveability. The best news is any of these short-term mortgages could save you thousands of dollars when compared to 30-year-fixed rate mortgages.
How a short-term mortgage works
A short-term mortgage combines a fixed-rate element, where the rate never changes over the life of the mortgage, and a variable rate component, where the rate can vary monthly. Think of a hybrid loan as a hybrid car that uses both gas and battery power to get you where you need to go. Normally, hybrid rates are listed in mortgage charts below the rates for the fixed-rate mortgages and adjustable rate mortgages.
You’ll see these hybrids listed as 3/1, 5/1, 7/1 or 10/1 (but there’s no reason why you couldn’t have a 4/1 or an 8/1). The first number, or front-end, is the length of the fixed-rate term, which simply means your initial interest rate will stay fixed for three, five, seven or 10 years. The second number, or back-end, refers to how often the rate will adjust, after the fixed rate period ends. So, with a 3/1 mortgage, for example, you pay a fixed rate for three years. In the fourth year, and every year thereafter until your loan balance is paid off or refinanced, your interest rate will change annually.
Because a short-term mortgage contains more risk for the lender than 30-year fixed rate loans (because interest rates could rise higher than what the borrower’s fixed rate is), the lender rewards the hybrid borrower with a lower rate for sharing some of its risk.
As such, a 3/1 involves more risk than a 5/1, a 5/1 more risk than a 7/1, a 7/1 more risk than a 10/1 and a 10/1 more than a 30-year fixed-rate mortgage. Therefore, the borrower who takes out a 3/1 would realize greater savings than his fellow 5/1, 7/1 or 10/1 borrowers. The 3/1 borrower is fixing his rate for only three years, living with more risk than the 10/1 borrower who is fixing his rate for 10 years.
Now let’s analyze how these differences translate into real savings for the first-time homebuyer by comparing the 5/1 ARM, the most popular hybrid product, with a 30-year fixed-rate mortgage.
For easy-math purposes, let’s say a 5/1 ARM in today’s market has an interest rate that is fixed for the first 5 years at 3.5 percent, compared to a 30-year fixed rate mortgage at 4.5 percent. This scenario should be fairly realistic, according to Ted Rood, a national mortgage advisor with Wintrust Mortgage in St. Louis, Mo.
“As a rule of thumb, a .25 difference is a safe number between gaps,” he said. So, shaving .25 from a 30-year fixed rate to a 10/1, to a 7/1, to a 5/1, should be somewhere in the ballpark.
Now let’s compare monthly payments for the first five years of both loans:
$1,013 year fixed at 4.5%*
$898 year fixed at 3.5%
That’s a savings of $115.28 a month or $6,916.80 for the first five years (60 payments).
Do some more comparison shopping with our mortgage calculator below.
Adjusting to new payments
After 5 years/60 months, the interest will adjust annually based on an index (1 year LIBOR or 1 year Treasury/CMT), plus the lender’s likely margin of somewhere between 2.25% and 2.75%. Your new yearly adjusting interest rate will be applied to your remaining 25-year (300 payments) loan balance.
“Few homeowners are comfortable with ever-changing monthly rates, hence the enduring popularity of the 30-year mortgage,” Rodriguez said. “Yet, with a hybrid, if you can get in and get out before the fixed-rate period expires, you can save a lot of money.
“Hybrids are ideally suited for first-time homeowners who know they’ll be moving at a particular time or anticipate an opportunity to pay off the mortgage early. The trick is to be out of the house or in a higher paying job before the interest rate resets. With hybrids extending out to 10 years, you have a lot of leeway.”