When first deciding on the type of VA loan, the initial decision is likely to select a fixed rate or an adjustable rate loan, or ARM. There are some basic questions that need to be answered when deciding between the two and still sometimes even when those questions are answered it's still almost a toss-up. The Federal Reserve's Quantitative Easing program combined with a rather tepid economy has helped keep interest rates as low as they are for at least a couple of years. So which do you choose: fixed or adjustable?
Generally speaking, when deciding between a fixed rate and an ARM, if rates are at or near historic lows at the time an interest rate is being locked in, the fixed rate is probably the better choice. On the other hand, if interest rates are at relative highs, then perhaps an ARM is the ideal loan.
Yet the way mortgage rates have been for the past decade, that sage advice may not always apply. Back in the 1980s interest rates were in the high ‘teens, it made sense to select an ARM. Adjustable rate mortgage loans offer an initial rate that is artificially low, called a "teaser" rate, meaning the start rate for an ARM is lower than its fixed rate cousin. When rates are high and it appears they're not going any higher, then an ARM is the selection in anticipation of falling rates. But wild interest rate swings have mostly gone away and double digit rates for conventional loans vanished around 1992 and over the past couple of years, fixed rates and adjustables were very nearly the same.
So is the ARM no longer a viable option?
An adjustable rate mortgage is comprised of an:
- Adjustment Cap
- Lifetime Cap
The index is a value set by third parties typically tied to things such as the London Interbank Offered Rate, or LIBOR or perhaps a one-year treasury.
The margin is a predetermined amount that is added to the index to arrive at the newly adjusted interest rate to calculate the monthly payment.
The adjustment cap is a consumer protection feature that limits how high or low a new rate can adjust based upon the index and margin.
The lifetime cap limits how high the rate may ever be throughout the life of the loan.
For example, a veteran has an adjustable rate mortgage and is set to adjust next month. The index is based upon the one-month LIBOR, the margin is 2.00 and the adjustment cap is one percent. At the adjustment date, if the index is 0.25% the new rate adjusts to 0.25 + 2.00 (margin) = 2.25%. The ARM will adjust annually and the veteran's new rate will be 2.25 percent until the next adjustment the following year. Now let's say that one year later the index is 4.25%, what will the rate be for the next year? The new rate attempts to be 4.25 (index) + 2.00 (margin) = 6.25% (fully indexed rate).
Yet there is an adjustment cap of 1.00% each year, so the increase can be no greater than 1.00% above the previous rate of 2.25. Even though the rate attempts to blossom to the fully indexed rate of 6.25 it can only be 1.00% greater than the previous year.
The lifetime cap on VA ARM's is 5.00% above the initial rate so if the start, or teaser rate, is 2.50%, the rate may never be higher than 5.00 + 2.50 = 7.50, regardless of what the one-month LIBOR index is at the time of adjustment through the entire life of the loan.
Today, VA ARMs are in the form of hybrids, identified as 3/1, 5/1, 7/1 and 10/1. A hybrid is so-called because it mimics both a fixed rate and an ARM. The first digit signifies how long the rate will be fixed before it turns into an adjustable rate mortgage.
A 3/1 will have a fixed rate for three years and a 5/1 for five years and so on. After the initial fixed period, the loan will adjust annually based upon the index, margin and caps.
Is an ARM a choice today? It can be. If you think you'll be moving or otherwise not have a mortgage during the initial hybrid term, it might make sense. Hybrid ARMs will have a lower rate than a fixed. Not by much, but lower nonetheless. Run your scenario by your loan officer and see how the numbers match up.
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