Understanding VA Hybrid ARMs – Terminology
The hybrid ARM offering in the VA loan program is one of the best-kept secrets of the program. Utilizing the VA hybrid ARM can save you as a borrower tens of thousands of dollars. The purpose of this article is to go over the terms you need to understand in order to make a good choice about your VA hybrid ARM, and to explain the basics of how a VA hybrid ARM works. For more details on these terms and about the VA hybrid ARM, check out our video on YouTube. The first thing we need to define is what hybrid ARM. ARM stands for adjustable-rate mortgage, and is the opposite of a fixed-rate mortgage. A traditional ARM (not a hybrid) has an adjustable interest rate that usually adjusts annually to match or come closer to market rates at that time. A fixed-rate mortgage is more common; the borrower is locked into a certain interest rate during the application process and has the same interest rate for the entire duration of the loan, independent of market fluctuations. A hybrid ARM is somewhere in the middle of a traditional ARM and a fixed-rate mortgage.
In a VA hybrid ARM, the interest rate is fixed for a certain number of years at the beginning of the loan, then adjusts annually throughout the rest of the loan. You have the ability to choose how many years the interest rate will be fixed, and there will be several options of which note rates to choose from. You’ll also want to check out the differences between the margins you are being offered by different lenders, make sure they are charging the same index, and make sure they are following VA guidelines in terms of adjustment caps, frequency, and ceilings. If nothing in the last sentence made sense to you, you are in the right place. We are going to cover the terms you just heard so you can understand them when your lender uses them.
The term “note rate” refers to what the initial interest rate for the fixed period will be. On a 3-1 hybrid ARM, the interest rate will remain fixed for the first three years of the loan, then be adjusted annually afterwards, no more than 1 percentage point in either direction. Usually lenders will offer two or three different options for a starting note rate, and while it may be tempting to choose the lower one, there are other factors you need to consider when doing so – sometimes it may actually save you money in the long run to choose a higher note rate in exchange for a better margin come later. We’ll cover what a margin is in a moment, but first, the note rate for VA hybrid ARMs is usually either 2.25% or 1.75%. You read that correctly, the higher of the two (2.25%) is a full two percentage points lower than what the conventional mortgage arena is offering for fixed-rate mortgages. This is the first reason hybrid ARMs are so advantageous.
The terms “margin” and “index” are closely related. Margin and index are added together to determine your interest rate after the initial fixed period. To clarify, on a 3-1 hybrid ARM, after three years, the note rate disappears and never returns, and is replaced with a new rate calculated by adding together the margin and index. Now, what is the margin? The margin is determined by the lender, and is essentially what they’re willing to offer you on the loan. The margin should not change throughout the loan; it should remain constant. The margin the lender offers you will depend greatly on which note rate you choose. If you choose the 1.75% note rate, you will likely be offered a higher margin than if you had chosen the 2.25% note rate. It’s a numbers game, but crunch them to find out if the lower rate for the first three years is worth the higher margin for the rest of the loan term. Right now, LowVARates is offering a 2% margin if a qualified borrower chooses a 2.25% note rate.
The index is how the lender keeps the interest rate current with the market as it fluctuates. The VA loan program uses the CMT index, which is not really that important to know except that it tells you that you shouldn’t worry too much about volatility. The CMT index is calculated annually and averages all 12 months in the year, which makes it representative of trends rather than isolated events. Currently, the CMT index is at .1%. So if three years ago, you chose a 2.25% note rate on a 3-1 VA Hybrid ARM, your interest rate would actually drop to 2.1% (margin+index) this year.
You’ll also hear the terms “caps”, “ceilings”, and “floor” in relation to your interest rate. What you need to know is that in the VA loan program, your interest rate is not allowed to adjust more than 1% in each direction each year, and cannot increase by more than 5% over the life of the loan.