Banks and credit unions make money the old fashioned way- they lend money and charge interest, something that has been going on since the invention of currency.
For an automobile loan or a credit card, consumers typically first contact their bank or credit union where they already have an account. In comes the adjustable rate home loan.
These institutions are more than aware of this relationship and know they’re more than likely to receive a request for a credit card or personal loan because the bank or credit union already has the consumer’s personal information such as account and social security numbers as well as where they live and how long they’ve been a customer. This “captive” audience can wind up paying higher rates on these loans if they’re not careful because they don’t comparison shop.
Another way banks and credit unions charge interest is on mortgage loans. Mortgage bankers, those whose sole function is to provide financing for residential and commercial real estate are typically more competitive when financing a home compared to a bank’s offering. That’s easy to figure out just by doing some comparison shopping on your own by calling your local bank and a mortgage company. However, banks and credit unions can also issue mortgage loans using their own internal lending guidelines and keeping the loan in their portfolios. Most conventional mortgage lenders today sell the loans they issue. Doing so frees up additional capital to make still more loans. Portfolio lending however can mean a bank or credit union has very little competition because not very many other banks offer the program. Portfolio loans are a money-maker for banks and credit unions because whatever the cost of funds are at the time a loan adjusts the bank’s margin provides the expected profits. With a fixed rate loan, when current markets rates are higher than a fixed rate loan the bank owns, it’s considered a loss as the loan is “marked to market.” This is the primary reason portfolio loans are adjustable in nature.
This is highlighted by a loan called a “5/5” adjustable rate mortgage. Similar to a 5/1 hybrid, but with a twist.
Hybrid Mechanics
A hybrid loan is so-called because it’s a variation on an adjustable rate mortgage, or an ARM. A hybrid is fixed for the first few years and then changes into a standard one-year ARM. Hybrids are most commonly referred to as 3/1, 5/1, 7/1 and 10/1 programs with the first digit representing how long the rate is fixed and the second how often it will adjust at the end of the fixed term. A 3/1 hybrid will have a rate fixed for three years and after that it can adjust once every 12 months.
The adjustment is based upon an index such as a 1-year Treasury Bill and adding a margin to that index. For example, if the index today was 0.50 and the margin 2.25, the new rate for the following year would then be 0.50 + 2.25 = 2.75%. There are also consumer protections called interest rate caps that can limit how much the new rate can adjust over the previous rate. For example, if an ARM has a 2.00% cap, no matter how high the rate tries to be at the next adjustment, it cannot be any higher than 2.00% over the previous rate. Hybrids will have slightly lower starting rates compared to a fixed rate and are generally the choice for those who plan to sell or otherwise retire a mortgage before the first adjustment. As well, the shorter the fixed term the lower the initial rate. A 3/1 hybrid will have a lower fixed rate than a 10/1.
Understanding this we can now see how a 5/5 hybrid works out. The rate is fixed for five years and then after five years the rate adjusts based upon the index and the margin and stays there for the next five years. This program takes some of the uncertainty out of anticipating what the rate will be in six, seven or eight years for example. Instead of adjusting annually once the fixed period has expired, the rate adjusts and stays at that rate, whatever it turns out to be, for the next five years.
No more wondering what the rate will be for the next five years.
There’s some peace of mind in that aspect. But indeed, the opposite could take place and the decision to take a 5/5 hybrid over a 5/1 might backfire. The rate could be much, much higher. And if that happens, the property owner has some decisions to make.
The trick with a 5/5 loan is waiting to see what the index will be in five years. And no one can see that far into the future. With an annual adjustment and rate caps, at least there is some consumer protections built in and interest rate “shock” will be mitigated.
The Five Year Wait
Okay, let’s take an example of what could happen at the end of five years and rates at that time are not as low as they are today. And that’s probably very likely as current rates have been near historic lows for a few years now. The lowest 30 year fixed rate averaged 3.34% in late 2012 according to Freddie Mac’s weekly mortgage rate survey. If you were to take out a 5/5 loan today it would set to adjust in the year 2021.
Let’s say you’re borrowing $1 million to buy a home and like the 5/5 program. Your rate today might start out at something like 3.75%. The 5/5 hybrid index is based upon the 1-year LIBOR rate, or the London Interbank Offered Rate plus an index of 2.25%. Your principal and interest payment for the first five years based upon 3.75% and an amortization period of 30 years is $4,631.
Everything is going well over the next few years and somewhere around the 58th month of the initial period, your lender advises you the rate will adjust per the terms of the note. In 2021, the LIBOR rate turns out to be 1.65%. Adding the margin of 2.25% to this rate and for the next five years you’ll be paying 3.9% for the next five years. The new payment would then be $4,716. Not bad. You guessed right.
On the other hand. Let’s say you didn’t exactly time it right. Let’s say inflation had ticked up beginning in year three of your new mortgage and the Fed has been desperately trying to keep ahead of the inflation curve and has bumped up the Fed Funds rate four times in the past 12 months. Likewise, the 1-year LIBOR is also on a roll. The economy has gained traction and back on its feet after a sluggish 10 years.
It’s about time, right?
Anyway, so you get the letter from your lender telling you to get ready for your new rate which will stay the same for the next five years. No need to worry about annual adjustments, you say to yourself.
The letter informs you the LIBOR rate is now 5.50% and with your margin of 2.25% the new rate you’re married to until the year 2026 is $7,164.
We didn’t quite time that one correctly this go-round, did we?
That’s the point with a 5/5 hybrid. While the notion sounds very attractive and the initial five years has a slightly lower rate than a 30 or 15 year fixed rate loan, there is considerable uncertainty looking that far into the future. If someone plans on keeping a home for 10 years or more and like the idea of a 5/5 loan due to the lower start rate and one-time adjustment, it might very well be a better choice taking a fixed rate loan.
If you guessed bad and the rate adjusted much higher than you hoped you can always refinance into another loan but there are closing costs associated with that move and if the LIBOR rate is much higher in five years you can be other rates will be as well.
All mortgage options should be considered after determining which programs most align with your financial goals. The 5/5 might be one of those programs but when you examine the program more thoroughly one can begin to understand it’s more of a marketing ploy designed to get your loan into a bank or credit union’s portfolio.
A Real Story On Adjustable Rate Home Loan…
The 5/5 at first glance seems to be an ideal choice when considering a 5/1 or a fixed rate loan yet the program once more thoroughly evaluated appears to be nothing more than a marketing ploy to get your loan into a bank or credit union’s portfolio of loans. The 5/5 program makes sense for someone who plans on keeping a loan longer than five years and avoiding annual adjustments from that point forward but in reality the 5/5 might be the less attractive choice.
If someone plans on keeping the loan for say eight or nine years then a 10/1 might be the better option. For those looking at keeping mortgage even longer, a fixed rate loan of 10, 15, 20, 25 or even 30 years seems to be the ideal option especially as rates are as low as they are today.
Mortgage lenders, banks and credit unions have been known in the past to create a new type of mortgage program to attract more borrowers but we all know what happens when banks start getting creative with new loans. If you’re being coaxed by a bank or credit union into taking out a 5/5 loan, take another look. You might be locking yourself into mortgage program that can backfire.
