Pros & Cons of an Adjustable Rate Mortgage for Military Homebuyers
Military homebuyers are different from the typical civilian buyer. Most buyers look for a home to move into and live for an indefinite number of years. However, military homebuyers know that our time in a home is temporary. For this reason, an adjustable-rate mortgage (ARM) could serve us better than a fixed-rate mortgage (FRM).
Let's explore why the pros of an adjustable rate mortgage could outweigh the cons for military homebuyers.
Risk Factors of an Adjustable Rate Mortgage
Many buyers favor an FRM because it’s considered low risk. Since the interest rate remains constant from the time you take out the loan, you’re immune to market fluctuations. This can be great for homebuyers looking to own a home for an extended number of years.
ARMs assume a great deal of risk. The rates can rise, and then you’re stuck paying a significantly larger mortgage each month. Additionally, if your ARM has a limit on how much you can pay on your loan each month, you risk a negative amortization--when payments don’t keep up with interest and will wind up more in debt.
But if you plan to only keep the home for the length of your PCS orders and then sell it, these risks associated with an ARM lowers.
Potential Benefits of an Adjustable Rate Mortgage
Most banks will start an ARM at a lower interest rate since you are absorbing the market’s shifts. If you plan to only own the home for a few years before selling it, you may not even feel a shift in the market--the chances of an astronomical increase in the market within the few years you plan to own the home are minimal.
ARMs are also great if you know you will promote soon. Since service members' pay is public knowledge, you know that today you can only afford a lower rate mortgage, but next year you might be able to afford an increased mortgage payment.
Plus, you don’t have to pay to refinance your home to adjust your mortgage rate. Since FRM’s are established at a set rate, if the homeowner wishes to lower it at any point, they must pay to refinance which can equal several thousand dollars. But ARMs shift with the market and don’t require the additional fees to effort to adjust should the market lower.
Types of Adjustable Rate Mortgages
But there’s more than simply choosing an adjustable rate mortgage. You need to consider which type of ARM and cap to instill in order to minimize risk.
The three types of ARMs are 10/1, 7/1, and 1. The numbers on the left (10, 7, and 1) indicate how many years the interest rate is fixed before it's open to adjust every year thereafter. The rate of fluctuation is determined by your cap.
Let’s say the lender offers a 1% periodic cap. Your mortgage can’t increase beyond that 1% in the given time, but could continue to increase by 1% each period. However, should you set a lifetime cap of 5%, your mortgage could increase by 5% in one year but would never extend beyond that 5% in the years to come.
Another type of mortgage loan is the hybrid ARM. The hybrid remains fixed for a minimum of three years and then follows the typical ARM model.
Military Friendly Lenders
We talked about basic benefits associated with an ARM, but perhaps the biggest benefit of an ARM for military homebuyers is the accessibility of FHA and VA Home Loans
Getting a VA Home Loan means that you’ll not only have the basic benefits like no down payment, competitive interest rates, and no private mortgage company, but you’ll also be protected from the pre-payment penalty if you pay off your loan before it matures.
An FHA loan requires mortgage insurance, which protects the lender should you fail to make mortgage payments and since the lender’s risk decreases, so does your interest rate.
These government-backed loans offer protection for borrowers by offering a 1/1/5 ARM loan. This type of loan means that the highest your interest rate can increase the first time is one percent, each adjustment is also capped at one percent, and the rate can’t increase beyond five percent for the life of the loan.
When You Don’t Want to Choose an ARM
As a military homebuyer, the time that it may be best to forgo an ARM and consider an FRM is if you plan to keep the property as a rental investment. Obviously, the window for your interest rate to increase broadens and your risk goes up.
Let’s say you live somewhere that your Basic Housing Allowance (BAH) is high, such as Hawaii or California. Your allowance may cover the cost of your mortgage and then some. But what if you PCS somewhere with a lower BAH; can you still afford your mortgage or an increase for that matter? You can argue that a renter will cover the mortgage which negates any fluctuation in BAH, but there are two things to consider here:
- What if the market is slow and renters are difficult to find?
- What if your mortgage increases beyond an appropriate rental price?
Another time to pass on an ARM is when you intend to pay off the property within 15 years of owning it. Most ARMs are written for 30 years. If you can afford the higher payments, choose an FRM, pay the balance on your loan quicker, accrue less interest, and ultimately save more money.
Making the Decision
There are pros and cons to both an ARM and an FRM. You can look at the facts, but at the end of the day you need to sit down and consider all the variables. Are you planning to keep the house for 10 years or more? Do you plan to sell after three years? What's the housing market like right now? While conventional wisdom might say to select an FRM, consider your circumstances, finances, and intentions.
For more information about ARMs for military members, see this article by Veterans United.