Taking out a VA loan means you have a big choice to make – do you want a fixed rate or adjustable rate loan? ARMs used to be a very popular type of loan, but in recent years, more people have opted for fixed rates because rates have been so low. This doesn’t mean, however, that choosing a rate that adjusts is the wrong decision.
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Here we’ll discuss how the ARM works and what you should consider.
What is a VA Adjustable Rate Loan?
The VA offers what they call hybrid adjustable rate loans. A portion of the term is comprised of a fixed rate and the remaining will adjust. Most commonly, borrowers get a 3/1, 5/1 or 7/1 ARM. The first number indicates the length of time the rate is fixed. A 3/1 term would have a fixed rate for the first 3 years. The remainder of the term consists of annually adjusting rates. The same is true for the 5 and 7-year term. They just have a longer fixed rate period.
How Does the ARM Work?
VA protects veterans from harmful lending practices. One way they protect lenders taking an ARM is with caps on the interest rate adjustments. The VA has an annual and lifetime cap.
- Annual cap – Every adjustment period, the interest rate cannot exceed 1% of the previous rate. This helps keep your payment as close as it was previously, eliminating payment shock.
- Lifetime cap – Over the loan’s entirety, the rate cannot adjust more than 5% from the initial rate. This allows you to determine the ‘worst-case’ scenario to determine if you can afford the fully adjusted rate.
Here’s how the adjustments work:
You take out your loan at the pre-determined rate. You keep that rate for the fixed period; let’s say 3 years in this case. After that 3rd year, the rate adjusts according to its index. The most common index lenders use is
Libor. When the rate adjusts, the lender determines the Libor rate at that time. They then add to it the ‘margin.’ This is the pre-determined amount the lender quoted you that they will add to the index at every adjustment.
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However, you have to keep in mind the caps. Let’s say your initial rate was 4% and your margin is 2%. It’s time to adjust and Libor is 4.5%. Using the standard formula, your new rate would be:
4.5% + 2% = 6.5%
However, the annual cap of 1% keeps the rate at 5% rather than the 6.5% adjusted rate.
What’s Better an ARM or Fixed Rate?
Whether an ARM or fixed rate is better is a personal decision. Take into account your plans. Is this your forever home? If so, a fixed rate might be better. You don’t have to worry about the payment adjusting and you won’t pay more interest than necessary.
However, even if you plan to stay in the home and you take a VA adjustable rate, you can refinance the loan. However, this is a gamble because you have no idea what rates will be a few years in the future. If rates are higher, you could be stuck paying more interest than necessary.
If you know this is a temporary home for you, however, an adjustable rate could work to your benefit. If you are able to take the lower rate on an ARM, you’ll save money in the end. Even though you take on the risk of the rate adjusting, if you’ll move before the rate adjusts, you’ll be in a good position.
Finding the Right Lender
As always, you should shop around with different lenders to determine which rate is right for you. Don’t just focus on the rate, though.
Look closely at the closing costs and the term of the loan. Ask yourself if you can comfortably afford the payment. Also, look at the APR. This gives you a better idea of how much the loan costs you over its entire life.
Once you have all of the facts, you can determine the right choice for you. An adjustable rate loan has many benefits, especially if it’s a short-term position for you. ARMs are also good for borrowers that don’t have the best credit right now. It gives you time to better your position, giving you the chance to secure a better rate in the future on a new VA loan.
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