We've really seen low rates this year, some reaching near the levels not seen since the fall of 1998. Many who refinanced their loans locked in the low, long term fixed rates. Still others got an even lower rate....they got a hybrid loan.

What's a hybrid mortgage?

Mortgage hybrids are a cross between and fixed rate and adjustable-rate mortgages. They generally have fixed rates for the first three, five, seven, or ten years and then they convert to adjustable-rate mortgages (ARMs) for the remainder of the loan term.

A "5/1 ARM" is an ARM that is fixed for five years, then turns into a 1-year adjustable mortgage. A "3/1 ARM" is fixed for three years, and so on.

Hybrid loans are sometimes also called "two step" financing and can be described as 3/27, 5/25, and 7/23 loans as well. Of course, whatever the loan is called, be certain you understand all costs, terms and conditions.

With hybrid loans the fixed rates are established up front and -- of course -- do not change during the first part of the loan term. Once the fixed-rate portion of the loan ends, the mortgage then behaves like an ARM with rate changes and monthly payments moving up or down each year as interest levels evolve.

ARMs are based on an agreed upon index, with common indices being the 1-year Treasury (sometimes called the 1-year T-Bill), a 6-month CD, the 11th District Cost of Funds index (11th District COFI), or the London Interbank Offering Rate (LIBOR). To compute the ARM interest level you take the index plus a margin established when the loan is first originated.

When the index and the margin are added together, that's called the "fully indexed rate." As of this writing, the 1-year Treasury index is 3.60%. If the margin is 2.75%, your fully indexed rate would be 3.60 + 2.75, or 6.35%. And today, that's a darned good rate.

On the other hand, exactly one year ago this same index stood at 6.09%, so by adding the 2.75 percent margin your fully indexed rate would come to 8.84%!

Adjustables can go up or down, but to prevent wild fluctuations most ARMs come with annual interest rate caps, lifetime interest caps, and monthly payment caps.

So what makes a hybrid attractive? The advantage is that start rates for hybrids are usually below fixed-rate mortgages.

A borrower can sometimes find a 5/1 ARM rate at up to a full percentage point below a comparable fixed rate loan, and for several years the homeowner will then reap the rewards of a lower rate. Generally, the shorter the fixed-rate period, the better the up-front discount, the longer the fixed-rate period, the smaller the discount when compared with 30-year fixed-rate financing.

But what happens after the fixed-rate period ends? Then you have an adjustable-rate mortgage -- unless you have already sold the home or refinanced the loan.

If you like the lower start rates of adjustable rate mortgages but don't like their inherent "swings" from one year to the next, think hybrid. It could be the best of both worlds.

For more articles by David Reed, please press here.

Published: August 2, 2001

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, a veteran Mortgage Banker, successful Real Estate Consultant and author of Your Guide to VA Loans, Mortgages 101: Quick Answers to Over 250 Critical Questions About Your Home Loan, Who Says You Can't Buy a Home!, and Mortgage Confidential: What You Need to Know That Your Lender Won't Tell You, is a former columnist and Contributing Editor with San Diego-based Mortgage Originator Magazine. Reed is President of CD Reed Mortgage Bankers, Austin, TX and is a Past President of the Austin Mortgage Bankers Association.