Home Buying: Should Service Members Heed the Call to ARMs?

May 2008
By J.J. Montanaro

Buying a home is a big decision. So is choosing how to pay for it. Among service members who PCS frequently, it can be difficult to justify the costs of buying a house when they’ll only have to sell it and move again a few years later. That common dilemma is what leads many military families to choose an adjustable rate mortgage.

When you apply for a mortgage, you have two main categories to consider: fixed rate and adjustable rate. Simply put, a fixed rate mortgage keeps the same interest rate over the life of the loan. With an adjustable rate loan, the interest rate starts low but may go up over time.

Adjustable rate mortgages (ARMs, for short) are attractive for one key reason: an ARM costs the buyer less money during the first few years. Compared with the typical 30-year fixed rate mortgage, the starting interest rate on an ARM can be significantly lower. The lower interest rate means your monthly payments will also be lower. With lower payments, you may be able to buy a nicer house, or just pocket the savings.

ARMs have become especially popular in the military community, and here’s why: although the payments on an ARM are likely to rise after the first few years, many service members count on selling the house and PCSing again before that happens.

It’s a strategy that, if played carefully, can work in your favor and save thousands of dollars in mortgage payments over several years. For example, if you bought a $200,000 house with a fixed rate 30-year mortgage at 7 percent interest, your monthly payments would be about $1,330. By comparison, with an ARM that started at 6 percent interest, your payment would be about $1,199 per month. Over three years, that difference of $131/month would save you a total of $4,716.

The offer of a lower interest rate can be enticing, but make sure to do your homework before opting for an ARM.

ARM Yourself with Knowledge

As in most situations, there are pros and cons to each type of mortgage and it pays to have a firm grasp on the basics before making one of the biggest purchases of your life.

ARMs are usually defined by a set of two numbers, such as 3-1 or 5-1. The first number is the initial period of the loan, during which your interest rate won’t change. So, if you take out a 5-1 ARM at 6 percent interest, your rate will be locked at 6 percent for the first five years. If indeed you PCS again and sell the house before those five years are up, you’ve succeeded in using the system to your advantage. But, if you’re still in the house after five years, more numbers come into play.

The second number in the 5-1 formula is the adjustment period. This tells you how often the bank can adjust the rate after the initial period has ended. So, 5-1 means that adjustments could happen every year after the initial five-year period.

How does the bank decide whether to raise or lower your interest rate? The rate on your ARM will be linked to an economic index, such as U.S. Treasury securities. When the index rises, so does your rate, and while one selling point of ARMs is the possibility that your payments could actually go down, you’d be safer to assume they’ll go up.

Even when rates rise, however, most ARMs give homebuyers some protection in the form of “rate caps.” A periodic rate cap limits the amount your interest rate can increase from one adjustment period to the next. A lifetime rate cap limits how much the rate can increase over the life of the loan.

For example, the 3-1 and 5-1 ARMs available through the Department of Veteran’s Affairs (VA) allow a 1 percent periodic adjustment and a 5 percent lifetime adjustment.

Even with rate caps in place, rising interest rates can have a big impact on your payments, turning your affordable home into a monthly source of stress. For that reason alone, most lenders advise against ARMs if you plan to live in the house longer than five years.

Have a Backup Plan

Just when you think you’ve got it all figured out, life can throw you a curve ball. For service members, that could mean staying put when you counted on PCSing again, and if you’ve taken out an adjustable rate mortgage, it could come back to bite you.

Let’s stay with the example provided earlier, where you bought a $200,000 house with an ARM that started at 6 percent interest. We’ll assume it was a 5-1 ARM with rate caps of 1 percent annual adjustment and 5 percent lifetime adjustment. Again, that means your payment would stay at $1,199 for the first five years and then potentially go up one percent each year for the next five years. After ten total years in the home, your interest rate could swell to 11 percent. And your monthly payment could max out at $1,791, nearly $600 more than where you started.

Drastic rate increases aren’t what most people have in mind when choosing an ARM, but it’s certainly within the range of possibility. If you find yourself in a similar situation, the good news is that you’re not necessarily stuck with the ARM forever. Most ARMs contain a conversion clause that allows you to switch your ARM to a fixed rate mortgage. The conversion option allows you to refinance without the burden of shopping around and requalifying for a fixed rate loan. Although there will be a fee to convert, it’s usually much less than the full closing costs on a new loan.

The process of converting could cancel out some of the savings you’ve achieved from the ARM so far, but it’s better than sticking with an ARM that could cost you even more in the long term. In any case, conversion should always be a backup plan when choosing an ARM, not your strategy from the beginning.

As you contemplate your next move, be sure to work with a reputable lender and ask as many questions as it takes for you to feel comfortable in your decision.

Ultimately, a key factor in choosing the right type of mortgage is to make reasonable assumptions about the future. For service members accustomed to moving every few years, the ARM can be another valuable tool to help secure a healthy financial future.

Joseph “J.J.” Montanaro is a CERTIFIED FINANCIAL PLANNERTM practitioner with USAA Financial Planning Services, one of the USAA family of companies. Montanaro served in the U.S. Army for six years on active duty during which he PCSed four times. He is currently a Lieutenant Colonel in the U.S. Army Reserve.

USAA is a diversified insurance and financial services organization that has served the military community since 1922. USAA Financial Planning ServicesSM refers to financial planning services and financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California), a registered investment adviser and insurance agency, and its wholly owned subsidiary. USAA means United Services Automobile Association and its affiliates.