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 in for the foreseeable future. As a military homebuyer, you know that time in any specific home is temporary. This fact alone begs the question, Is an adjustable-rate mortgage (ARM) better than a fixed-rate mortgage (FRM) if you’re a military homebuyer?
Let's explore why the pros of an adjustable-rate mortgage could outweigh the cons for homebuyers in the military community.
Risk Factors of an Adjustable-Rate Mortgage
Fixed-rate mortgages have more favor among the public because they’re considered low risk. The interest rate remains constant from when you take out the loan, granting you immunity from market fluctuations, and this can be great for homebuyers looking for longevity with their new property.
Adjustable-rate mortgages can leave the general population cringing because they’re inherently riskier. With an ARM, you’re at the mercy of the housing market. As it fluctuates, so does your interest rate.
Let’s say that you bought a home in 2021 when the average interest rate was favorably low at 2.94%. Then 2022 came, and interest rates rose to 6.5%. You inevitably saw a significant increase in your mortgage each month. And while rates aren’t astronomically high, when compared to the time you purchased your home, they are. And it's undoubtedly enough to throw off a carefully calculated budget.
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Another factor that deters many homebuyers from choosing an ARM is the limits associated with it. If your ARM limits how much you can pay on your loan each month, you risk a negative amortization.
With a typical home loan, the overall balance gradually reduces each month as you pay your mortgage. But with negative amortization, the effect reverses. Negative amortization is the gradual increase in the overall amount owed when the buyer can’t keep up with the interest rate. Simply put, if you can’t afford to increase your payment to match the rising market you'll fall deeper into debt.
Sounds scary, right? How does one ensure there’s enough room in the budget to account for drastic fluctuation?
There’s a particular scenario where ARMs assume less risk—if you intend on keeping your home for a short duration. For military homebuyers who move frequently, considering an ARM makes sense, unless you’re buying a home as an investment property or retiring. Why? Because you’re more likely to dodge heavy swings in the market.
But that’s the tipping point into why an ARM might be a good choice for military homebuyers. Let’s take a closer look.
Potential Benefits of an Adjustable-Rate Mortgage
After covering all the risks, you’re probably wondering what’s left to be desired with an adjustable-rate mortgage? There are a few reasons.
Most banks will start an ARM at a lower interest rate since the buyer absorbs the market’s shifts.
If you plan to only own the home for a few years before selling it (as mentioned previously), you may not even feel a budge in the market. The chances of an astronomical increase within the few years you plan to own the home are minimal. Having said that, the 2021 and 2022 housing markets proved that the prices can change overnight. The risk, while reduced by a quick buy/sell turnaround, is never fully dissolved.
ARMs can be a good option if you know you will promote soon.
Since service members' pay is public knowledge, you know what next year's higher pay will be and whether or not you can afford an increased mortgage payment. This should help you avoid negative amortization and growing your debt.
You don’t have to pay to refinance your home to adjust your mortgage rate, unlike FRMs, which are established at a set rate.
With a fixed-rate mortgage, if the homeowner wants to lower the interest rate (or overall amount owed), they must pay to refinance. Most home refinances can equal anywhere from 2% to 5% of your new home loan. ARMs shift with the market and don’t require additional fees to adjust your rate should the market lower.
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Types of Adjustable-Rate Mortgages
There’s more to discuss than simply choosing an adjustable-rate mortgage over a fixed-rate mortgage. Consider which type of ARM and cap to instill 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 adjustments every year after.
Your cap determines the rate of fluctuation. 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 then follows the typical ARM model.
Beyond the simple benefits of an ARM, perhaps the biggest perk for military homebuyers is the added accessibility of the 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 have an added protection for borrowers by offering a 1/1/5 ARM loan. A 1/1/5 ARM sets a one percent cap for each increase to your mortgage and states that the rate can’t increase beyond five percent for the life of the loan.
The combination of an ARM, a quick buy/sell turnaround, and government-backed financing like the VA loan can shield military homebuyers from the risk of an adjustable-rate mortgage.
See: Your Step-by-Step Guide to Using the VA Loan.
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How to Know if An Adjustable-Rate Mortgage is Right For You
Sifting through the pros and cons of an adjustable-rate mortgage is crucial to understanding the process. But you need to dig deeper into your intentions with the property if you want to determine if an ARM is the right financing option for you.
Three things to consider before choosing an adjustable-rate mortgage.
1. How long you plan to own the property.
Although military homebuyers counter some of the risk associated with an ARM with their lifestyle alone, a fixed-rate mortgage might be the better choice if you plan on holding onto the property for the foreseeable future. The longer you own the home, the more likely you'll feel the market's fluctuations.
2. Your Basic Housing Allowance.
Let’s say you live somewhere where 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 some factors to consider with that, which we'll cover in the next point.
3. Whether or not you plan to rent out the property when you PCS.
As stated, longevity is a huge factor when deciding between an ARM and FRM. But let’s say for a minute that you do rent out the home when you move. The goal with a rental investment is to have rent payments cover the mortgage payment (and then some). But what if your mortgage increases beyond an appropriate rental price? Coupled with the financial risk of an empty rental, a higher mortgage payment could have you spending out of pocket.
In summary, some cases where a FRM might be better than an ARM:
- If you’re buying a rental investment property.
- You’re buying a home that you plan to retire in.
- You’re unsure whether you want to sell or rent the property when you move.
Another time to pass on an ARM is if 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, an FRM should allow you to pay the balance on your loan quicker, accrue less interest, and ultimately save more money.
You can look at the facts until your eyes cross, but at the end of the day, it's best to sit down and consider all the variables. Are you planning to keep the house for ten 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 a fixed-rate mortgage instead of an adjustable-rate mortgage, consider your circumstances, finances, and intentions.