If you've heard about adjustable-rate mortgages (ARMs) in the past couple of years, you probably didn't catch anything too positive. ARMs took a big hit during the housing market crash in 2007.
With mortgage rates starting to rise, ARMs are staring gain popularity again, especially with buyers who aren't expecting to live in their home for too long. That can definitely include service members and military families.
The key to using an ARM to your advantage is to find the right loan at the right time. An adjustable-rate mortgage is riskier than a fixed-rate mortgage, but it also presents unique advantages for the right homebuyer.
ARMs are more restrictive on on government-backed mortgages, like the VA Loan. That can help minimize risk and make an adjustable-rate mortgage worth a closer look. They're absolutely not the best fit for every borrower, but they can make financial sense in the right circumstances.
Fixed-Rate vs. Adjustable-Rate
If you're ready to settle down and have put all of your time into the service already, a fixed-rate mortgage is probably the best option for you. This type of loan typically has a life span of 15 or 30 years and allows borrowers to have a consistent interest rate through the life of the loan (unless you refinance).
The clear advantage is no matter what is happening with economy, your rate won't change. If interest rates quickly rise, you won't feel any of the financial burden.
When it comes to an adjustable-rate mortgage, you're going to be exposed to more risk but have a better chance for potential reward. ARMs typically begin with a lower interest rate than a fixed mortgage, possibly allowing you to qualify for a bigger loan. The lower interest rate is subject to an adjustment on an annual basis of one-, three- or five-year Treasury securities while lenders tack on a "margin" of one or more percentage points.
If you can't decide between a fixed-rate and an adjustable-rate mortgage, some lenders offer a mix of the two: a hybrid ARM. This option has a fixed interest rate for a certain amount of time before it becomes eligible for annual adjustments.
A 5/1 hybrid ARM has a fixed interest rate for five years before it reverts back to the system of a traditional ARM. The initial period of the hybrid ARM helps bring borrowers some comfort with the certainty in their payments during this time.
A 5/1 hybrid VA ARM could allow you to use the lower initial interest rate to save money and build equity. This loan option could be the perfect fit for military borrowers especially those who are likely to PCS soon.
Loans backed by the government are designed to help provide affordable and accessible opportunities for homeownership. With a VA or FHA adjustable-rate mortgage, there comes a government-mandated 1/1/5 cap:
- 1 percent is the highest your rate can increase on the first adjustment
- 1 percent is the limit on each subsequent annual adjustment
- 5 percentage points is the maximum the rate can increase over the life of the loan
Here's an example of how that works.
Let's say you get a 5/1 VA hybrid ARM for $100,000 and 2.5 percent interest equaling a monthly payment of $500. The earliest the interest rate on the loan could change is five years after closing. After five years, the interest rate increases by a maximum of 1 percent to 3.5 percent for a new monthly payment of $553. The next year, the interest on the loan increases by the maximum of 1 percent again to 4.5 percent for a $611 monthly payment.
With the 5-point government cap, the earliest a borrower could reach the cap would be in year 10 of the mortgage. The monthly payment could only increase as high as $804 with 7.5 percent interest.
Taking Advantage of ARMs
Home prices and interest rates rose in 2013 and look to continue to climb in 2014. Even those the interest rates can rise over time, the lower initial rate allows homebuyers to have an affordable monthly payment for the time being.
This time also provides borrowers an opportunity to save up and prepare for if/when the interest goes up on their mortgage. The best way to take advantage of this time, especially if you have a 3/1 or 5/1 ARM is to create a budget with a higher mortgage payment than you're paying. That extra money can be put into a savings account to use to help offset the increased costs.
For example, if you were to only add an additional $50 to your budget for mortgage payments, you could save $1,800 for the initial three years or $3,000 after five years. Remember there are rate caps in place and interest rates aren't guaranteed to go up.
As long as you are dedicated to planning and sticking with a strategy, an adjustable-rate mortgage can be a huge benefit for veterans and military families seeking homeownership.
Chris Birk is director of communications for the VA Mortgage Center, which specializes in VA loans for veterans and active duty service members.