When you have applied for any type of financial loan, most likely you had the option to apply for either a fixed or variable interest rate. As the finance industry is always changing to keep up with consumer trends and spending habits, a new type of interest, a hybrid interest rate, has been introduced. The new hybrid rate is a combination of the traditional fixed and variable interest rates for a variety of loans including student loans, home mortgage loans, and student loan consolidation.
How Do Hybrid Interest Rates Work?
Before explaining what a hybrid interest rate is, let’s refresh on what the two traditional interest rates are. A fixed interest rate keeps the same rate for the life of the loan. This means a 10-year student loan with a fixed 5.25% interest rate will remain 5.25% until the loan is paid in full.
With a variable interest rate loan, the same 10-year student loan might begin with a 2.5% interest rate could remain the same for the entire ten years, but, it will most likely fluctuate as the LIBOR or Prime interest rates go up and down. This means the interest could go below 2.5% or go as high as 8.95% if interest rates rise sharply.
Hybrid interest rates are a combination of a fixed rate and variable rate. Sticking with the 10-year student loan example, a hybrid student loan will have 5-year fixed interest rate followed by a 5-year variable interest rate.
How Does the Hybrid Interest Rate Differ From Fixed and Variable Interest Rate Loans?
Lenders will usually offer a lower-than-usual fixed rate for the 5 years compared to the standard 10-year fixed interest rate. The fixed rate for the hybrid loan would be 4.06% compared to the standard fixed interest rate of 4.61% for the entire 10-year repayment term. After 5 years, the hybrid loan’s fixed interest rate of 4.06% switches to a variable rate of currently as low as 3.27%.
The primary advantage of a hybrid interest rate is the potential cost savings from a slightly lower fixed interest rate in the beginning and the ability to get an even lower variable rate. The hybrid interest rate allows borrowers to get the lowest interest rate possible for the first five years of their student loan payments. Hybrid loans allow borrowers to strike a “happy balance” when they want to potentially save a few extra dollars instead of having to fully commit to a traditional fixed or variable interest rate loan.
Possible Benefits of a Hybrid Interest Rate
Hybrid loans aren’t for everybody, but, they can be a great option for others. These are some of the ways that a hybrid student loan can benefit you.
Lowest Possible Interest Rates
To help entice borrowers to apply for hybrid loans compared to going with a fixed or variable interest rate, lenders will offer a slightly lower interest rate for the fixed rate portion. Assuming you have a $10,000 student loan with a 10-year repayment term, the monthly payment with a traditional fixed interest rate of 4.61% will be about $104 each month and $2,500 in cumulative interest payments.
With a hybrid loan, the total estimated interest paid will be around $2,000 because the monthly payment is $101 for the first five years with a 4.06% fixed rate and slightly drops to $99.58 when the fixed rate changes to a 3.27% variable rate for the final five years. Assuming the variable interest rate remains the same for the second 5-year period, that’s a savings of $500 for each $10,000 borrowed.
Hedges Risk Against Future Interest Rates
Hybrid loans are a great alternative to borrowers that want low-interest rates without the risk of a 10-year variable loan. As nobody can accurately predict if interest rates will rise or fall beyond the three months from now, a variable interest rate loan can have a current interest rate as low as 3% for the first year and gradually ratchet up to 8.95% (the interest rate cap for most variable rate loans) for the remaining 9 years.
While this is scenario is extremely unlikely, it is possible for a variable rate loan to begin lower than a fixed rate and increase to a rate higher than the original fixed rate for the majority of the repayment term and make the variable rate more expensive than the fixed loan. A hybrid loan secures a fixed rate for the first five years when a majority of the monthly payment is applied to interest instead of the principal. If variable rates sharply increase, the additional cost is only during the final five years when the loan balance is smaller.
Ideal Option for Prepayment with 10-Year Repayment Terms
This can be the cheapest option for student loan refinancing for those needing a 10-year repayment term. It’s often recommended to only choose variable rates loans when you plan to repay the loan within 5 years to hedge against the risk of rapidly rising interest rates. If the new loan has a term of 10 years or longer, it’s recommended to get a fixed interest rate. Refinanced hybrid loans with a 10-year termsecure an interest rate lower than the typical fixed interest rate.
It might not be cheaper than a traditional variable rate, but, it’s another way refinancing can save money because it’s cheaper than a traditional fixed-rate loan. The hybrid rate allows those that need more than five years to repay their loans to secure cheaper interest rates.