When deciding on a VA loan, you have a few choices to make. You have to decide on the loan term, or the amortization period. This is the predetermined time it takes to gradually pay off your VA loan. These periods range from 10 years up to 30 years with five year increments. Once you decide on your term, you then choose from a range of interest rate options, higher or lower depending upon whether or not you want to pay points to get a lower rate or pay no points at all. But there's one other important choice: fixed or adjustable?
The Choices
Historically there have been two primary choices regarding a VA mortgage program. A fixed rate mortgage and an adjustable rate mortgage. A fixed rate is what it says it is; the rate never changes throughout the term of the loan.
On the other hand, an adjustable rate mortgage, or ARM, is a loan program where the rate may change in the future under specific rules.
Today, the ARM program has moved away from a six month or a one year adjustable rate loan to the hybrid model. What's the difference between the two?
Until recently, a borrower could select a VA adjustable rate loan that could change annually. This loan was called, appropriately, a one-year ARM. Each year, the loan could reset to a new rate on its anniversary date and the borrower would make payments on the mortgage using the new rate until the rate changed again the following year.
Now, VA ARM programs have largely moved away from a one-year ARM and come in the form of a hybrid.
The Hybrid Breakdown
A hybrid is so-called because it performs like both a fixed as well as well as an adjustable rate loan. A hybrid has a fixed rate for an initial period, as short as three years before turning into a one-year ARM. These initial periods are offered in 3, 5, 7, and 10 year terms.
These loans are identified by 3/1, 5/1, 7/1 and 10/1.
How do they work?
After the initial fixed period, it's adjustable all the way. The rate can change on its anniversary date based upon the index, margin and caps.
What's the index? The index is the starting point when calculating a new rate and is a commonly held index such as the Prime rate, the one-year Treasury or other indices. Today however, one of the most common indexes used is the LIBOR, which stands for the London Interbank Offered Rate.
The next component is the margin. The margin is an amount added to the index to arrive at the new rate. Both are locked in the mortgage documents expressing which index will be used as well as what margin will be added.
For example, say today you had a VA hybrid for 3 years and are coming up on your anniversary date. On your anniversary date, your lender looks up the LIBOR and sees that it's 0.50%. Your margin is 2.25% and by adding the two together, your rate for the next 12 months is 0.50 + 2.25 = 2.75%.
Capping It
Now let's say that the LIBOR rate has, shall we say, gone up a bit since your adjustment. What happens if the LIBOR index went from 0.50 to 10.00? That won't happen, but let's just say that it does. Your new rate for the following year is 10.00 + 2.25 = 12.25%! What? You can't afford that, can you? Your mortgage payment would skyrocket.
Caps are placed on all VA hybrid loans. A cap is a limit on how much the interest rate can rise both at the adjustment period as well over the life of the loan. An annual adjustment cap is one percent over the previous rate and five percent over the life of the loan.
Again using this example, while the rate would attempt to go all the way to 12.25%, the rate would limit it to just one percent above the previous year's rate. If your rate for the last year was 2.75%, the highest it could be at the anniversary adjustment is 3.75 and 5.00% above your start rate.
Fixed rates have been all the rage over the past few years due to the historically low rates we've experienced. Hybrid loans on the other hand, can offer a slightly lower start rate compared to a fixed before turning into an ARM.
Before choosing between a fixed or a hybrid, talk with your loan officer. There are advantages to both.
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