VA Vs. Conventional: The ARM Loan
The VA loan program has a very different offering in terms of ARM (adjustable-rate mortgage) loans than the conventional loan program. Why is this relevant? Because the VA’s ARM option (technically called a ‘hybrid ARM’) is significantly better than the conventional ARM option. To adequately explain how a VA ARM is better than a conventional ARM, we’ll first go over some ARM basics, then talk about the conventional ARM, then talk about the VA ARM.
An adjustable rate mortgage is exactly what it sounds like; a mortgage in which the interest rate periodically adjusts. An ARM is the opposite of a fixed-rate mortgage. ARMs have typically been given a pretty bad rap, and in fact are often what people point fingers at to blame for the housing market bubble bursting. While the role ARMs played in the housing bubble is debatable, the fact that some ARMs are better or worse than others is indisputable. ARM loans typically are limited to annual adjustments, and usually have a lifetime cap of how high they can rise above their starting rate, as well as adjustment ceilings for how much it can fluctuate. ARM interest rates are calculated by combining the margin a lender offers at the beginning of the loan, which can’t change after closing, with the index being used for that ARM loan. With those basics out of the way, let’s talk about the different offerings.
The Conventional ARM
Conventional ARMs are generally not that great. Both VA and FHA ARMs have the leg-up on on Conventional ARMs. The conventional ARM usually adjust once per year, but the frequency of rate adjustments is something to keep an eye on if you’re applying for one. When a conventional ARM adjusts, it can go as much as 2% higher than it was previously, which can make for some drastic increases depending on the market activity. However, the conventional ARM does have a lifetime cap of 5% higher than the starting rate, so no matter what the market does, your loan can never be higher than 5%. Conventional ARMs typically start with a fixed period of 3-10 years, after which the rate starts adjusting. It’s important to know that on a conventional ARM, the very first year it adjusts, it can adjust as far as it needs to to catch up with where the market is at that time, up to the 5% lifetime cap. In other words, even the minimal 2% annual cap protection is not present in the first adjustment. The conventional ARM uses the LIBOR index, which can be volatile and result in less predictable adjustments.
The VA Hybrid ARM
The VA Hybrid ARM is a different story. VA ARMs also adjust once per year, but they have an annual adjustment cap of no more than 1% higher, and that protection is in place for the first adjustment after the fixed period. Fixed periods on VA ARMs are typically shorter, between 3 and 7 years, but starting interest rates are even lower than on conventional ARMs. VA ARMs share the 5% lifetime cap with conventional ARMs, but when combined with a 1% annual adjustment limit, this is a far more reasonable limitation. VA ARMs use the 1-year CMT for their index, which is an average of the CMT activity for the last 12 months. This averaging makes the CMT much more smooth and less volatile than the LIBOR, which results in easier-to-predict adjustments that generally aren’t as likely to jump up or drop down very drastically.
It’s All In The Numbers
If you want to know for sure how much better a VA ARM would be for you than a conventional ARM, apply for an ARM with two different lenders, one conventional and one VA, and that will be your proof. ARMs are great in that they start with (usually) a much lower interest rate than fixed-rate mortgages, with the tradeoff that they can adjust over time. If you have the protections built-in that the VA ARM comes with, the risk of suddenly having a payment you can’t afford is much, much lower, and the chances that you’ll end up paying more in the long run for your ARM is much lower as well.