Broadly speaking, two types of mortgage exist: fixed-rate and adjustable-rate. However, the VA offers a middle ground that provides some advantages to both of these loan options. As such, we’ll use this article to explain how VA hybrid loans work.
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VA Loan Overview
VA loans – fixed, ARM, or hybrid – offer eligible borrowers an outstanding home buying option. The program began in World War II to provide returning troops an affordable mortgage option. Currently, the Department of Veterans Affairs administers the program, and VA loans offer the below advantages:
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, borrowers need to understand that the VA doesn’t actually issue loans. Rather, the Department guarantees a portion of every loan issued by a VA-approved lender (e.g. banks, credit unions, mortgage companies, etc.). That way, if a borrower defaults on a loan, the VA will pay the lender a percentage of the outstanding loan balance.
With this system, lenders must meet certain criteria for any VA loans they offer. But, it also means that the individual lender – not the VA – determines what loan products it will offer. Accordingly, service members and veterans considering a VA hybrid loan should first confirm that their lender offers this product.
Fixed-Rate Mortgages
Before explaining hybrid loans, borrowers first need to understand how fixed-rate and adjustable-rate mortgages work. The major difference between these two options hinges on loan interest rates. More precisely, will these rates change or stay the same over the life of the loan?
As the name suggests, fixed-rate mortgages have the same interest rate over the entire loan term. For example, if you take out a $250,000, 30-year mortgage 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 in the future.
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.
Adjustable-Rate Mortgages
This name also clearly explains the mortgage. With adjustable-rate mortgages, or ARMs, borrowers will 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%.
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.
To calculate the new rate on an ARM, lenders use both an underlying index and a margin. Think of this underlying index as a baseline. For example, many lenders 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%).
ARMs 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.
VA Hybrid Loans
VA-approved lenders now offer a middle ground between fixed and ARMs: the VA hybrid loan. With this product, borrowers get a fixed-rate introductory period (the fixed-rate period). At the conclusion of this period, the loan converts to a standard ARM (the adjustable-rate period).
For example, borrowers could take out a 5/1 VA 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, 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, a VA hybrid loan’s fixed-rate period must be at least three years. Lenders can offer longer periods than this, but they cannot offer shorter ones.
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 VA hybrid loans a great option.
Interest Rate Considerations for VA Hybrid Loans
VA-Imposed Maximum Annual Interest Increase
Historically, ARMs hurt borrowers due to massive annual jumps in interest rates. For instance, people may have seen 5% jumps in a single year, potentially adding hundreds of dollars (or more) to their monthly payments.
To protect against this, the VA caps annual increases at 1%. This means that, if you have a 3% interest rate, it can’t increase to more than 4% during an annual adjustment. While this will likely still increase your monthly payments, it limits the shock of a massive jump.
VA-Imposed Ceiling on Total Rate Increases
Additionally, the VA imposes a ceiling on the total allowable rate increase over the life of a loan. During the entire loan, lenders cannot increase your rate by more than 5%. Assume you take out a 3.5% 5/1 VA hybrid loan. For the first five years, you’ll have the introductory 3.5% interest rate. Each year during the adjustable period, it can potentially increase by another 1%. But, you’ll never have an interest rate greater than 8.5% (3.5% initial rate + 5% maximum total increase).
Final Thoughts
VA hybrid loans combine the advantages of fixed-rate and adjustable-rate mortgages. Depending on a borrower’s time horizon, they may be a great choice. With a VA hybrid loan, you can access the low introductory rates of an ARM with the front-end stability of a fixed-rate loan. But, borrowers must still factor in the potential risk of a rate increase up to 5%.
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.
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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.
