Hybrid mortgages fall between a fixed rate and an adjustable rate loan. Lenders realized that there was a market for borrowers who wanted the lower cost of an adjustable loan but were afraid of a possible interest rate increase within a short time. The lenders also realized that some interest rate adjustment was better than none at all.
The hybrid mortgage loan begins with a fixed rate for a set time. The most common fixed periods are three, five, seven, and ten years. At the end of the fixed term, the loan adjusts to the agreed-upon index rate plus the margin. Further adjustment is most commonly annually, although the adjustment period may be every three, or even every five, years. The loans are categorized by their overall term, then fixed term, then adjustment period. A thirty-year loan with a three-year fixed term and a one-year adjustment period would be expressed as a 30/3/1 loan. A fifteen-year loan with a five year fixed term and an adjustment period every three years would be expressed as a 15/5/3 loan.
At the end of the fixed interest period, the loan is recalculated to reflect the new interest rate. If you borrowed $100,000 on a 30/3/1 loan, for example, the loan would be recalculated at the end of three years. Your payment would be based on the new interest rate (index rate plus margin), term remaining (twenty-seven years), and the principal balance ($100,000, less the amount of principal paid during the first three years). Each succeeding year would have an interest rate adjustment based on a change in the index rate, with a resulting payment adjustment.