What if Rates Keep Going Up?
Let’s get to the root of this question: How big is the risk you’re taking by getting a hybrid ARM instead of a fixed-rate? Well, let’s talk about it. First, we’ll talk about the safeguards that the VA has put in place on a hybrid ARM to protect borrowers from getting sky-high interest rates, then we’ll take a look at what the CMT index has done over the last little while to get a feel for how likely it is that it’s going to jump up a large amount over an extended period of time. Finally, we’ll wrap up by talking about whether it’s worth the risk and what is the smartest thing to do for your mortgage.
The VA has put some very important safeguards in place to make sure that VA borrowers are not put in a bad spot by getting a hybrid ARM. The first safeguard is actually the initial fixed period itself. At the beginning of the loan, more of your monthly payment is going towards interest than at any other time during the loan, so getting an insanely low interest rate for the first 3-5 years can save you a lot of money in a very short amount of time. After the initial period, the hybrid ARM can only be adjusted once each year, and cannot adjust more than 1% in any given year. This means that even if rates skyrocket after your fixed period, you’ll be the tortoise chasing the hare. Lastly, the VA does not allow an interest rate to increase more than 5% over the life of the loan, even if market rates go much higher than that. Considering that you have up to 5 years at a fixed rate, then it would take a minimum of 5 years for the interest rate to rise the full 5% (by the way, this has never happened in the history of the CMT index – ever. Literally, your chances of dying by getting hit by a meteor are higher than this happening.) So it would take 10 years for your loan to max out by then, and since the average time between refinances or moves for american families is between 3 and 5 years, you will probably have moved or refinanced by that point anyway.
So how has the CMT index performed over the last while? Well, below is a graph that shows you what the CMT index has done since February of 1992. As you can see, while there are years where the CMT does go up, it has never gone up for more than 3 years in a row. The specific color you should be looking at is the blue line, which indicates the 1-year CMT that will be used to calculate your hybrid ARM index.
So the CMT index does not have a habit of increasing for very many years in a row. While the index can jump several percentage points in just one or two years, it doesn’t generally maintain growth for longer than 2-3 years.
What does all this mean? Well, since the hybrid ARM is limited to increase more than 1% each year, it doesn’t matter if the index jumps 1% or 10% in a year; you’ll only go up 1%. As long as the index comes back down (which it has for the last 22 years), your rate will go down as well. While it may go up slowly over time, we’re talking between 15-25 years, and by then you’ve saved so much money over your fixed-rate buddies that you’ll almost certainly still come out ahead. Asking “what if” about the worst-case scenario with your rate is an exercise in futility in this case. While planning for the worst is often a good practice, it can be taken to extremes, and this is one of the cases where trying to “plan for the worst” is just going to rob you of opportunities and benefits you could otherwise enjoy. Much like refusing to leave your house because you might get hit by a car, deciding against a hybrid ARM because you’re afraid of your rate rising as far as it can as fast as it can is more paranoia than caution.