A Closer Look at VA Adjustable-Rate Mortgages (ARMs)

The popularity of VA adjustable-rate mortgages (ARMs) is increasing again with the current rate environment.

The odds are you haven't heard much about VA adjustable-rate mortgages (ARMs) in the last few years. However, the popularity of this product is increasing again with the current rate environment.

A VA ARM can make good financial sense for some borrowers, especially those still serving. Below we dive into VA ARMs and what borrowers should know about this mortgage product when purchasing a home.

VA borrowers actually have a built-in advantage when it comes to ARMs. Government-sponsored loan programs are more restrictive, which minimizes risk for Veterans and military families without limiting their options. To be sure, there’s inherently more risk in an ARM than with a fixed-rate mortgage, which will have the same interest rate for the life of the loan.

But they might be a savvy fit for homebuyers who don’t plan on staying in one place for too long. And if anyone knows about frequent relocation, it’s military homebuyers.

It’s important to understand the risks and the potential advantages of ARMs when considering what type of loan to pursue. Let’s take a closer look.

Fixed v. VA ARM

Fixed-rate mortgages feature a consistent interest rate for the life of the loan. If you lock and close at 4.75 percent, you'll have that same rate 15 or 20 years down the road (provided you don't refinance). There are clear advantages, namely the certainty that your rate won't change despite what's happening in the overall economic environment.

The flip side is that if interest rates fall sharply, as they have over much of the past few years, your fixed rate might wind up being higher than what many new homebuyers are enjoying. At that point, the only way to capitalize on those lower rates is to refinance, which will cost you money.

With an adjustable-rate mortgage, you’re exposed to more risk and potential reward. An ARM will typically begin with a lower interest rate than what you’ll find on fixed-rate loans. That lower rate means you’ll have more money in your pocket, which can even help you qualify for a bigger loan. The rate on an ARM is subject to change depending on a host of outside economic factors. If rates are steady or falling, that can help keep your adjustable rate under control.

The risk of ARMs is rooted in their uncertainty. A traditional, straightforward ARM comes with a low interest rate that’s subject to adjustment on an annual basis. That adjustment is tied to an economic index, often the one-, three- or five-year Treasury securities. In addition, lenders will tack on one or more percentage points, known as the “margin.” So your rate is the sum of the index rate and the lender’s margin.

VA Hybrid ARMs

A more specialized product, called a hybrid ARM, has become increasingly common. These have a fixed interest rate for a certain period before becoming eligible for annual adjustments.

For example, a 5/1 hybrid ARM features a fixed interest rate for five years, then reverts to the traditional setup. That period of fixed interest gives borrowers an initial degree of certainty regarding their payment.

Adjustable-rate mortgages with government-backed programs provide homebuyers additional protection.

Borrower Protections and VA ARM Rates

Government-backed loans are geared toward affordability, accessibility and expanding homeownership opportunities. An adjustable-rate mortgage with a VA or FHA loan comes with a government-mandated 1/1/5 cap.

Here’s what this means:

• The highest your rate can increase on the first adjustment is 1 percent
• Each subsequent annual adjustment is limited to a 1 percent increase
• The rate cannot increase more than 5 percentage points over the life of the loan

We’ll run through a quick example to see how this can work in practice.

Let’s say you have a 5/1 Hybrid VA loan at $100,000 and 2.5 percent, with a monthly payment of $500. The soonest that rate can change is five years after your loan closing. At the five-year mark, a 1 percent maximum increase to 3.5 percent would push the monthly payment to $553. A year later, another 1 percent increase to 4.5 percent would mean a $611 payment.

The government’s 5-point cap means the highest possible interest rate on this loan is 7.5 percent, which translates to a monthly payment of $804. The soonest you could hit that cap is year No.10 of your mortgage.

Finding the Fit

A 5/1 Hybrid VA ARM can make a lot of sense for some military borrowers. If you’re likely to PCS within five years, an ARM could present a unique opportunity to save money and build equity. That lower initial rate could even be what helps you qualify for a home loan in the first place.

Homeowners expecting to stick around longer than the fixed-rate period will want to evaluate their options more closely. There could be some critical reasons to have that low interest rate for a while before exposing yourself to potential increases.

You’ll want to consider your employment and the likelihood you’ll have the income to cover higher payments down the road. Will you be buying a car in a few years, or taking on loans for school or other needs?

These are conversations to have with your family and friends, along with your home loan specialist. The goal is getting the right mortgage for your specific situation.