Choosing the Right VA Hybrid ARM For You
This article assumes you already have foundational knowledge about the VA hybrid ARM. If you want to brush up on some of the terminology, check out our helpful video on YouTube, or if you want a fairly full understanding of the VA hybrid ARM program, check out our helpful guide here on LowVARates. Not all VA hybrid ARMs are created equal, and some ARMs will seem very tempting, but actually bring less total benefit some other seemingly less-appealing options. In this article we’ll go over many of the things you’ll need to consider when trying to decide which option to choose.
The first thing to consider is the relationship between the note rate you choose and the margin that the lender offers with it. Usually, the lender will offer a lower note rate in exchange for a higher margin at the end of the initial fixed period. In order to make the best decision, you will need to do some not-so-simple number crunching to determine which will save you more money. Is the low-margin, higher-note-rate combo more cost effective over the term of the loan, or is the high-margin, lower-note-rate combo going to keep more cash in your wallet? You’ll need to figure how much interest you’ll pay during the initial period with each of the note rates (usually 2.25% and 1.75%), then how much interest you’ll pay throughout the rest of the loan with each margin. For this calculation, you can ignore the index, as it will do it’s thing regardless of which note rate you choose. Like I said, this is a bit complicated, but let’s walk through an example together. You can make these calculations using one of many free mortgage calculators online.
Let’s say you are looking at a 3-1 hybrid ARM for a loan amount of $100,000. First, we need to calculate and compare how much interest you’ll pay with each note rate (so we are only considering the initial fixed three year period). For a 2.25% rate, you’ll pay $6,688.90 in interest in the first three years. For a 1.75% interest rate on the same loan, you will pay $5,186.96 in the first three years. So, a 1.75% saves you money in the first three years – anybody could tell you that. But on the 2.25% rate you were offered a 2% margin, and on the 1.75% rate you were offered a 2.25% margin. Remember that the margin (plus the index, which we are not worrying about) is what makes up your interest rate after the initial fixed period is over. So in this example, you’ll be paying the margin for the remaining 27 years of the loan. After the first 3 years of normal-amortizing payments, there will be $92,545 of principal remaining. With the 2% margin that you got with the higher note rate, over the remaining 27 years you will pay an additional $27,300.39 in interest. With the 2.25% margin that you got with the lower note rate, you will pay an additional $31,023.50 in interest.
So, if you chose the lower note rate (1.75%) with the higher margin, you will pay a total of $36,210.46 of interest on that $100,000 loan. If you chose the higher note rate (2.25%) with the higher margin, you will pay a total of $33,989.29 of interest. The higher note rate will have saved you roughly $2,700 over 30 years, making it the better choice in the long run. It’s important to note, that if this were on a 5-1 hybrid ARM, where the note rate is applied for the first 5 years instead of just the first 3, these numbers would be different, and it may even be that the lower note rate would be more advantageous even though it was paired with a higher margin. This is the second thing to consider – the relationship between the initial fixed period and the note rates and margins offered at each duration. The offered note rate and margin will usually change depending on the initial fixed rate, and those changes will affect the cost effectiveness of each option.
The last thing we’ll discuss here is the importance of remembering how interest is calculated. Interest is calculated by applying the rate to the remaining principal. What this means is that you are paying a larger dollar amount of interest at the beginning of the loan than you are at the end. This is because the same interest rate (let’s say 2.25%) is being applied to the remaining principal. At the beginning of the loan, you still have close to $100,000 of unpaid principal remaining, and the amount of interest is 2.25% of whatever the principal is. As you pay off more principal, the amount of interest you are charged gets smaller because 2.25% of any amount smaller than $100,000 is less than 2.25% of $100,000.