VA Adjustable-Rate Mortgages (ARMs)

Following the Great Recession, adjustable-rate mortgages received some bad press (some warranted, some not). However, for certain VA loan borrowers, this loan program can make sense. As such, we’ll use this article to provide an overview of VA adjustable-rate mortgages (ARMs).

Specifically, we’ll discuss the following:

• VA Loan Overview
• Fixed- vs. Adjustable-Rate Mortgages
• The VA Adjustable-Rate Mortgage
• What Makes Sense for Me?
• Final Thoughts

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VA Loan Overview

The VA loan program provides an outstanding home buying option for eligible borrowers. Administered by the Department of Veterans Affairs, these loans offer the following 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)

But, it’s important to note that the VA doesn’t actually lend money. Instead, it guarantees a portion of every loan issued by VA-approved lenders (e.g. banks, credit unions, and mortgage companies). As a result, the VA provides certain lending guidelines, while individual lenders establish their own unique loan products. This system provides lenders some flexibility in offering both fixed and ARM versions of VA loans, so long as they meet VA guidelines.

Fixed- vs. Adjustable-Rate Mortgages

Before discussing the VA ARM loan, we need to provide a brief overview of fixed- vs adjustable-rate mortgages, in general.

Fixed-Rate Mortgage

With this sort of loan, borrowers receive a single interest rate for the entire loan term. For example, if you take out a 30-year mortgage at 3.5%, you’ll have the same 3.5% interest rate over the life of the loan.

On one hand, fixed-rate mortgages significantly reduce risk for borrowers. Interest rates can vary widely over time. Locking in the same rate ensures you will pay the same amount over the entire loan, regardless of what happens with rates. In other words, if market rates increase from 3.5% to 7%, you keep paying 3.5%. This means that the principal and interest portion of your mortgage payment will be the same for the entire loan term. However, if you choose to refinance a fixed rate loan, you will receive a new interest rate for the refinanced loan.

On the other hand, fixed-rate mortgages also lock you into a higher interest rate if market rates decline. Say that, five years after taking out the above 3.5% mortgage, rates decrease to 2.5%. You’ll still need to pay principal and interest based on the 3.5% rate. But, you would also have the flexibility to refinance to take advantage of these lower rates, which limits the risk of missing out on these changes.

Adjustable-Rate Mortgages 

As the name suggests, ARMs have interest rates that can change over time. Borrowers receive an introductory rate. Then, this interest rate can adjust up or down on an annual basis, depending on what’s happening in the broader market. Typically, lenders peg ARM rates to one-, three-, or five-year US Treasury rates, adding a margin on top of the Treasury rate. With this system, your interest rate equals the Treasury rate plus the lender’s margin.

ARMs have two major benefits. First, introductory rates on ARMs tend to be lower than their fixed-rate counterparts. This can potentially provide borrowers more purchasing power. Second, in a declining rate environment, borrowers automatically take advantage of lower interest rates.

However, these benefits need to be weighed against the significant risk of an ARM. If interest rates jump, your monthly mortgage payments can potentially increase dramatically. For instance, say you take out an ARM with an initial rate of 3%. After two years, you have a balance of $250,000 but the interest rate has increased to 5%. Due to this jump, your monthly payment would increase by over $330 – a major hit to your household budget.

The VA Adjustable-Rate Mortgage

The VA ARM loan offers borrowers the benefits of traditional ARMs while protecting against some of the major risks. As the government backs these loans, it also establishes some clear guidelines for how individual lenders can structure the adjustable rates. Of note, VA ARMs must comply with the VA-mandated 1/1/5 structure. This means that:

• Interest rates cannot increase or decrease more than 1% annually.
• The rate cannot increase by more than 5% over the life of the loan.

On the plus side, this means that borrowers can still take advantage of A) low introductory rates, and B) automatic rate decreases with a VA ARM. But, in an environment of increasing rates, you still receive some protection by limiting your annual increase to 1% and 5% total.

But, even with a maximum increase of 5%, an interest rate jump of that magnitude can still significantly increase your monthly payments. For example, borrowers will pay nearly $875 more per month on a $250,000 loan that jumps from 2.5% to 7.5% over five years (ignoring the effects of amortization). Yes, you can certainly argue that such a jump is unlikely, but it’s certainly possible. It’s wise to plan for this worst-case scenario.

What Makes Sense for Me?

This depends on two primary factors: 1) your risk tolerance, and 2) your time horizon.

Risk Tolerance

If you stress tremendously about investment and financial risk, a VA ARM loan likely doesn’t make sense for you. The lower introductory rates and potential for annual automatic decreases likely won’t outweigh the stress of a potential rate increase. For these borrowers, the stability of a fixed-rate VA loan is likely the better choice, as this stability will help them sleep at night.

Time Horizon

If you’re only planning on staying in a home for a few years, a VA ARM may make sense. That is, the low introductory rate could justify any potential increases, as you’d only hold the loan for a limited period of time.

For these individuals, a hybrid VA ARM loan may actually be the perfect fit. This loan combines an initial fixed-rate period with a subsequent ARM one. For instance, a 5/1 hybrid VA ARM means borrowers lock in a low rate for the first five years, and rates won’t increase or decrease until the five-year mark. If you plan on PCS’ing and selling your house within five years, this can be a great way to secure a low interest rate.

Final Thoughts

VA adjustable-rate mortgages are not for everyone. While the government protections mean that these loans have less risk than traditional ARMs, borrowers still face the potential for significant interest rate – and monthly payment – increases. But, for borrowers with higher risk tolerances and shorter time horizons, the VA ARM can be a great choice.

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.