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How Do VA ARMs Work? And Should I Get One?
Eight Minute Read
Written by Ed Andrews III on July 29th, 2020
After the mortgage meltdown between 2007 and 2010 nearly every consumer in America believes that ARM loans (or Adjustable Rate Mortgages) are these horrible predatory products that banks originated at the expense of consumers.

Well I’m here to tell you that ARM loans are awesome when used in the right setting. Stay tuned and I’m going to tell you everything you need to know to determine whether or not an ARM loan is right for you.

Why We're Afraid of ARMs?

“I’m getting a fixed rate…..right?”

I can’t tell you how many times I’ve been asked that question. Over 95% of the time the answer is yes, but it’s generally being asked by people who don’t know if a fixed rate is the best option for them. They just believe ARMs are horrible loans that will ultimately lead to their home-owning demise.

The stigma around ARM loans comes from the fact that the interest rate can change. Everyone has heard the horror stories of someone whose interest rate continued to rise (thus increasing their payment) until the point where they could no longer afford the home. The end result was often they lost the home to foreclosure, or had to do a short-sale to get out of the loan.

Typically folks who experienced this also had their credit ranking destroyed. Thereby making it impossible to buy another home, and difficult to find a place to rent.

It's no wonder people are afraid of ARM loans.

But did you ever ask yourself why they got the ARM loan to begin with? Now granted some unscrupulous mortgage brokers put people into these loans with educating them on how they work, and there’s an extra small cubicle in hell for those lenders. But for people who have responsibly used ARM loans they get them for one reason……THE INTRO RATE BABY!!

Intro Rates, Adjustments, and Caps

Let’s talk about ARM intro rates, fixed periods, adjustments, and caps specifically for VA loans.

Traditional ARMs can adjust after the first year, but the VA allows veterans to obtain “Hybrid ARMs”. These are ARM loans that start with fixed rate periods of three, five, seven, or ten years. These fixed rate periods are always at the very beginning of the loan. This means that in the early years of the loan the rate cannot change.

The rate at the beginning of an ARM loan during the fixed period is commonly referred to as the intro rate. What’s attractive about ARMs is that this intro rate is often lower than what the veteran could get on a fixed rate loan. Since the rate is lower, their payment is lower.

After the fixed period ends the rate on the loan can adjust once a year. When you see a mortgage loan referred to as a 5/1 Hybrid ARM, that means it’s fixed for five years and can adjust once a year after that. The first number is always the length of the fixed period, and the second number is the frequency of the rate adjustments.

ARM loans have what are called rate caps, and VA is very particular about what the caps must be for a VA home loan. For any loan with a fixed period of less than five years the VA mandated caps are 1/1/5.

Let’s break these numbers down.

• The first number symbolizes how much the first adjustment can be. In this case that amount is 1%.

• The second number symbolizes how much all subsequent adjustments can be. For loans with fixed periods less than five years that is also 1%.

• The last number designates the most the rate can increase above the intro rate at any point during the life of the loan. This is called the lifetime rate cap. For loans with fixed periods less than five years that amount is 5%.

For VA ARMs with fixed periods of five years or greater the caps are 2/2/6.

What Makes the Rate Go Up (or Down)

So you might be asking what determines if my interest rate goes up. Well it’s completely based on what market rates are doing. When you get a fixed rate part of the risk for the lender (or investor that will eventually buy the loan) is they are agreeing to allow you tie up their money for the duration of the loan at a set rate of interest.

Think about it…if I let you borrow money today at 4% interest for 30 years and ten years from now market rates are 8%, I’ll be losing a considerable amount of profit on the money I have tied up in your loan.

This is why lenders give you a break on the initial interest rate when you get an ARM loan. It reassures them that in the future if market rates increase they’ll be able to adjust your rate accordingly and enhance their profits.

So the determining factor for your interest rate will be the index and the margin. The index is what your loan tracks. We don’t need to get too deep into the weeds, but just know that VA ARM rates are based on the one, three, or five year treasury securities (also known as the T-Bill).

In addition to the yield for the T-Bill, lenders will also charge a margin. A margin is what they add to the T-Bill yield to determine what your rate will be, it is also the source of their profits. Your margin will never change, but the index will move everyday.

Once a year, after your fixed period ends the lender will look at the margin. Then they'll adjust your rate accordingly, and recalculate your payment based on the amount of time you have left on the loan and the amount that you owe.

It’s really that simple. Your rate will go up and down as the index goes up and down. However, the caps are in place to ensure that if there’s spikes in the market your rate and payment adjusts at a milder pace than what may be happening in the market place.

To ARM or Not to ARM....That is the Question

So here’s where the rubber meets the road. Should you get an ARM? You may be thinking ARMs are a ridiculous idea. Why take the risk of making your payment unaffordable one day and losing your home just to save a few bucks at the beginning? I’ll tell you why it’s a smart move sometimes.

What are your plans for the future?

Are you retiring soon?

Do you plan to start a family?

Are you or your spouse currently going to college or grad school and expecting to earn more money in the future?

There is an endless amount of reasons why the home you’re buying may not be a home you plan to stay in indefinitely. And if you plan on moving in let’s say five to seven years for example, why do you need a 30 year fixed rate?

Think about a fixed rate as something you typically have to pay more for. If you plan on moving out of your property in several years, why are you paying more for a long term fixed rate you have no intention of using?

You might be saying, “Yeah Ed…we may plan to move, but you know what they say about best laid plans”. To that I say sure. Life happens, and it often doesn’t happen the way we planned. So get an idea of what impact a delay in your plans would have on your loan.

Let’s say for example you take out a $250,000 mortgage to buy a home, and you intend to sell the property in five years. In an effort to get a lower rate you opt to go with the VA 5/1 Hybrid ARM with an intro rate of 3.5%. But things don’t go the way you planned and you end up in the house two years longer than you expected. This is what that may look like (keep in mind these payments do not include property taxes or insurance).

Payment for years one though five - $1,122 
Balance at the end of five years - $224,242

Year six interest rate 5.5% (assuming it increases the maximum allowable by VA caps) 
Payment for year six - $1,377 ($255 higher than intro payment)
Balance at the end of year six - $219,943

Year seven interest rate 7.5% (assuming it increases the maximum amount allowable) 
Payment for year seven - $1,648 ($526 higher than intro payment)
Balance at the end of year seven - $216,538

The easiest way to give yourself some breathing room with ARMs in case your plans change is to make extra principal payments during the intro period. In keeping with the example above, let’s explore what that would look like if you paid an extra $150 a month towards the principal for the first five years.

Payment for years one though five - $1,272 
Balance at the end of five years - $214,422
Year six interest rate 5.5% (assuming it increases the maximum allowable by VA caps)

Payment for year six - $1,316 ($44 higher than intro payment with extra principal) 
Balance at the end of year six - $210,311
Year seven interest rate 7.5% (assuming it increases the maximum amount allowable)

Payment for year seven - $1,576 ($304 higher than intro payment with extra principal) 
Balance at the end of year seven - $207,055

You may look at this and become filled with fear and anxiety. If that’s the case this may not be a favorable option for you. Conversely, if you look at this and think “oh…that’s not that bad at all” then an ARM may be something you want to explore. Understand that I’m using a worst case scenario. For the most part interest rates have held steady between the 3s to 5s for the better part of the last ten years.

I’ve been in this industry for over a decade and I’ve yet to see a rate environment that caused a homeowner’s annual rate adjustments to consistently hit the caps. Despite all the hoopla around ARMs, people who have them have seen only nominal adjustments on their rates over the last decade.

Remember the lifetime caps are five or six percent depending on the length of your fixed period. So in the example I used above the rate can’t get much higher. Also note that as long as you’ve made timely mortgage payments you can always refinance a VA mortgage loan to a fixed rate loan. So if your plans to move change to you staying in the home indefinitely, you won’t be forced to ride the market rate rollercoaster in perpetuity.

With that being said, the most important thing here is the pricing. It makes no sense to take an ARM loan if the rate is equal to or only slightly less than the fixed interest rate you would qualify for. ARMs are a risk for the homeowner. You are opening yourself up to the possibility of significant increases in the rate of interest you will pay, and thus the affordability of your monthly payment.

When you take a risk there should be a subsequent reward. That reward is an intro rate significantly lower than the available fixed rate. In the absence of that discount in pricing, there’s no motivation for getting an ARM.

My intent is not to convince you to get an ARM. Rather my intent is to help you understand the benefit of ARMs, and inspire you to ask yourself the questions that will help you identify if this may be the right loan product for you.

Now that you understand how ARMs work you’re probably wondering what the best practices are for shopping interest rates. For more information about that be sure to watch my video “how to rate shop” were I’ll be breaking that down in detail and showing you exactly what to look for.
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VA Loans With Ed was created by a veteran for veterans. This is the premier source for veterans to learn everything they need to know about the VA loan, and get the most out of the benefit they earned.

About the Author:
Ed Andrews III

Ed Andrews III is a mortgage loan officer, and U.S. veteran of the Iraq & Afghanistan Wars. He is an expert on VA home loans, and dedicated to helping veterans achieve home-ownership.
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