When looking for a mortgage, borrowers want to find the best interest rates. But, they also need to balance long-term stability. In other words, should you take the stability of a fixed-rate mortgage or the lower initial rate of an adjustable one? To help answer this question for military borrowers, we’ll use this article to explain fixed vs ARM VA loans.
Specifically, we’ll discuss the following:
- VA Loan Overview
- Fixed-Rate VA Loans
- ARM VA Loans
- Fixed vs ARM VA Loans
- Final Thoughts
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VA Loan Overview
The VA loan has its origins in the Servicemen’s Readjustment Act of 1944. Informally known as the GI Bill, that legislation created a number of veteran benefits – including an affordable mortgage option. Today, the Department of Veterans Affairs administers the VA loan. The loan program provides the following outstanding benefits:
- No down payment required
- No private mortgage insurance (PMI) required
- Low interest rates
- Streamlined refinancing option via the Interest Rate Reduction Refinance Loan (IRRRL)
However, the VA doesn’t actually lend money. Rather, it guarantees a portion of every loan originated by VA-approved lenders (e.g. banks, credit unions, mortgage companies, etc.). This system reduces risk for these lenders. If a borrower defaults on a VA loan, the VA will pay the lenders a portion of that outstanding loan balance.
This VA guarantee comes with strings attached. When they issue VA loans, lenders must comply with certain VA guidelines. In other words, while lenders set their own loan terms, they must adhere to VA rules for any VA loans they issue.
Fixed-Rate VA Loans
As outlined above, VA loans – fixed or adjustable – do not require a down payment. This dramatically reduces the cash requirements to buy a home, making these loans great options. But, borrowers need to consider how they want to deal with interest rates over the life of their VA loan.
With a fixed-rate VA loan, borrowers pay the same interest rate over the entire loan term. For example, if you take out a $250,000, 30-year fixed-rate VA loan with an interest rate of 3.5%, you’ll make the same principal and interest payments for all 30 years (unless you refinance). In this instance, that means your principal and interest payment would total $1,133 for the entire loan.
This provides borrowers two key advantages. First, you gain financial stability, knowing that your mortgage payments won’t dramatically increase due to rate increases. Second, over time, economies generally experience inflation. This means that, relatively speaking, that $1,133 payment will cost you less 10 years later.
NOTE: While your principal and interest payments remain the same with fixed-rate mortgages, your total mortgage payment will increase. Most residential mortgages include property taxes and insurance in escrow, meaning a portion of your monthly mortgage payment goes towards those expenses. And, property taxes and insurance will increase over time.
ARM VA Loans
Alternatively, borrowers can opt for an adjustable-rate mortgage (ARM) VA loan. With these loans, 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, ARM VA 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 your monthly payment amount will change.
To calculate the new rate on an ARM VA loan, lenders use both an underlying index and a margin. For example, 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 the 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 VA 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.
Fixed vs ARM VA Loans
To determine what VA loan makes the most sense, borrowers should consider the below factors.
Time Horizon
The longer you plan on holding a mortgage, the more interest-rate risk you face. That is, say you only plan on living in a home for three years before selling it. With VA restrictions, your interest rate couldn’t increase more than 2% (2 annual adjustments x 1% max annual increase). If you receive a low enough introductory rate, you may be able to justify this risk.
Conversely, if you plan on living in a home for an extended period of time, you may want the monthly payment stability of a fixed-rate VA loan. Otherwise, you face the potential risk of a 5% total rate increase.
Risk Tolerance
If you stress tremendously about investment and financial risk, an ARM VA loan probably doesn’t make sense for you. The lower introductory rate likely won’t outweigh the stress of a potential rate increase. For these borrowers, the stability of a fixed-rate VA loan is often the better choice, as this stability will help them sleep at night.
Current Interest Rates
Generally speaking, ARM VA loans have lower introductory rates than fixed-rate mortgages. These lower rates make ARMs appealing. But, depending on the broader interest rate environment, the difference between ARM and fixed-rate interest may not be large enough to justify the increased risk of the former. If an ARM offers a 2.5% introductory rate compared to a 3% fixed rate, does that 0.5% advantage justify the risk of potentially having that ARM VA loan increase as much as 5%? Mortgage calculators can help you compare payment options to see if the difference between a fixed-rate and ARM VA loan makes sense for your unique situation.
Access to the VA’s IRRRL
Lastly, borrowers should consider the benefits of the VA’s streamlined refinance option, the IRRRL. Many people argue for ARMs, as borrowers automatically take advantage of lower interest rates. That is, if rates decrease, you don’t need to refinance – that decrease will be factored into your annual adjustment period automatically. On the other hand, if you lock into a fixed-rate loan, you miss out on these rate reductions.
But, the IRRRL is designed precisely for these situations. It allows borrowers with fixed-rate VA loans to quickly and easily refinance their loans to take advantage of lower interest rates. As such, access to the IRRRL provides borrowers the benefits of an ARM with the stability of a fixed-rate VA loan.
Final Thoughts
No absolute answer exists to the fixed vs ARM VA loan question. Rather, individual borrowers need to consider their unique situations and the characteristics of both loans. In general, borrowers with shorter time horizons may want to take advantage of an ARM’s low introductory rates. On the other hand, borrowers planning on staying in the same home for a while should consider the stability of a fixed-rate VA loan, especially when combined with access to the IRRRL program.
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.
