Historically, home buyers needed to decide between the stability of a fixed-rate mortgage and the lower initial rate of an adjustable-rate mortgage (ARM). Now, the VA offers eligible borrowers a compromise – the hybrid ARM. As such, we’ll use the rest of this article to help answer the question: ARM vs hybrid ARMs?
Specifically, we’ll discuss the following:
- An Overview of VA Loan Options
- ARM Definition and Considerations
- Hybrid ARM Definition and Considerations
- ARM vs Hybrid ARM
- Final Thoughts
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An Overview of VA Loan Options
The Department of Veterans Affairs used to offer two types of VA loans: a fixed-rate and adjustable-rate one. With a fixed-rate loan, borrowers have the same interest rate – and principal/interest payment – for the life of the loan. With an adjustable-rate loan, that rate can change on an annual basis. Now, the VA offers a compromise product – the hybrid ARM – that includes characteristics of both fixed-rate loans and ARMs. But, regardless what option borrowers choose, they still receive the following outstanding VA loan terms:
- No down payment required
- No private mortgage insurance (PMI) required
- Low interest rates
- Streamlined refinancing option via the Interest Rate Reduction
- Refinance Loan (IRRRL)
ARM Definition and Considerations
With adjustable rate mortgages (ARMs), borrowers receive an introductory rate, but then the interest will periodically adjust over the life of the loan.
Typically, ARMs have an annual adjustment. That is, your rate won’t increase or decrease more than once per year. For instance, you may receive an introductory rate of 3%. At the end of the first year, if interest rates increase, your rate will adjust upward. As a result, you may have a new rate of 5%. However, VA ARM loans offer additional protection. To shield borrowers from massive payment increases, the VA:
- Only allows one rate change per year.
- Does not allow an annual increase of more than 1%.
- Does not allow a total increase of more than 5%.
With these restrictions, a borrower with an initial rate of 3% will have a maximum interest rate of 8% (3% initial + 5% maximum total increase).
When one of these rate changes – increase or decrease – happens, lenders recalculate your monthly payment based on 1) your outstanding loan balance, 2) the new rate, and 3) the remaining term on the loan. In other words, if you have a 30-year loan, you’ll still pay it off in 30 years, regardless of rate changes. But, after these adjustment periods, your monthly payment amount will change.
To calculate the new rate on an ARM, lenders use both an underlying index and a margin. VA-approved lenders generally use the 1-year Treasury as their index. Next, the margin equals the lender’s premium they charge over that index. Total interest rate equals the index plus this margin. That is, a 1-year Treasury rate of 1.5% plus a lender margin of 3% would give you a 4.5% interest rate (1.5% + 3%). But, if the Treasury increased to 2.5% during the adjustment period, your interest rate would increase to 5.5% (2.5% + 3%). Fortunately, with VA restrictions in place, your ARM rate couldn’t increase by more than 1% in a given year, even if the underlying index does.
ARM loans provide borrowers the advantage of a low introductory interest rate – typically lower than their fixed-rate counterparts. But, these loans also come with more risk, as your loan payments can increase significantly if market interest rates increase.
Hybrid ARM Definition and Considerations
As stated, borrowers historically had to choose between a fixed-rate loan or an ARM. Currently, VA-approved lenders offer a middle ground between these options: the hybrid ARM loan. With this product, borrowers get a fixed-rate introductory period. At the conclusion of this period, the loan converts to a standard ARM.
For example, borrowers could take out a 5/1 hybrid ARM. This means that the loan will A) have a five-year fixed-rate period, and B) will not adjust more than once per year at the end of this fixed-rate period. As a 30-year loan, that means that borrowers would pay five years of the same principal and interest payments. Then, at the end of the five-year fixed period (and each subsequent year), that rate would increase or decrease. The lender would calculate the new monthly payment based on 1) the outstanding loan balance after five years of payments, 2) the new interest rate, and 3) a remaining loan term of 25 years (30-year loan – 5 years of fixed payments).
According to VA guidelines, with hybrid ARMs, the fixed-rate period must be at least three years. Lenders can offer longer periods than this, but they cannot offer shorter ones. Common hybrid ARMs include 3-, 5-, 7-, or 10-year fixed-rate periods.
This hybrid model provides borrowers two key advantages. First, you can receive the low introductory interest rates of an ARM. Second, you get the initial stability of a fixed-rate mortgage. That is, you know that your payments won’t increase due to interest rate changes during the initial period. For borrowers looking to sell a property within the fixed-rate period, these advantages can make hybrid ARMs great options.
ARM vs Hybrid ARM
To decide between an ARM or hybrid ARM, borrowers should ask the following questions:
How long do I plan on keeping the mortgage?
The longer you hold an ARM, the more interest-rate risk you face. If you plan on holding a loan for three years, you’ll only face two annual rate changes. However, if you plan on holding it for ten years, that’s nine annual rate changes, which could lead to a significantly higher interest rate. Generally speaking, the longer you plan on holding a home, the riskier a pure ARM over a hybrid ARM.
Are the introductory rates of the ARM significantly lower than the hybrid ARM?
Next, borrowers should look at the different initial rates between these two loan products. If a pure ARM offers similar interest rates to a hybrid ARM, it likely doesn’t make sense to select the ARM. Simply put, this situation means you get the benefits of an ARM (i.e. a low initial rate) with the stability of a fixed-rate mortgage (i.e. a fixed-rate payment period).
On the other hand, if an ARM offers a significantly lower rate than its hybrid counterpart, this lower rate may outweigh the increased risks of an ARM.
How comfortable am I with interest-rate risk?
Lastly, borrowers need to reflect on their personal risk tolerance. If you stress tremendously about investment and financial risk, a pure ARM loan likely doesn’t make sense for you. The lower introductory rate likely won’t outweigh the stress of a potential rate increase after one year. For these borrowers, the stability of a hybrid ARM (or fixed-rate mortgage) is likely the better choice, as this stability will help them sleep at night.
Final Thoughts
For most borrowers, the increased risks of an ARM make the hybrid ARM a better option. Both products face long-term risks of rising interest rates. But, the hybrid ARM’s initial fixed-rate period protects borrowers from that risk for a set amount of time. Furthermore, pure ARMs don’t always offer interest rates that much lower than hybrid ARMs. This means hybrid ARMs often provide the up-front benefits of an ARM with the stability of a fixed-rate mortgage.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.
