The Ultimate Guide to FHA Adjustable-rate Mortgages

FHA loans are federally insured mortgages that have become renowned for their borrower-friendly terms, making homeownership accessible to many. These loans offer options of either a fixed interest rate or an adjustable rate.

FHA adjustable-rate mortgages (ARMs), though less common (accounting for less than 1 percent of FHA loans originated in April 2024 according to federal data), provide significant advantages, notably a low introductory rate.

Before committing to an FHA ARM, it’s essential to understand the intricacies and workings of these mortgages. Here are the fundamental aspects of FHA ARMs.

First, let’s delve into how ARMs and FHA loans function.

An adjustable-rate mortgage (ARM) is a type of home loan with an interest rate that adjusts periodically. Initially, it offers a lower fixed rate for a specified period, typically three, five, seven, or ten years. After this initial period, the interest rate adjusts at regular intervals, such as every six months or annually, within predetermined limits. This adjustment can cause your monthly mortgage payment to fluctuate, potentially increasing or decreasing over the remaining loan term. Lenders assess ARM applicants based on their ability to manage potential payment increases.

FHA home loans are insured by the Federal Housing Administration (FHA) and are offered through FHA-approved mortgage lenders. These loans are designed for borrowers with lower credit scores, including first-time homebuyers, who may not qualify for conventional loans without a federal guarantee. FHA loans require a modest 3.5 percent down payment but mandate mortgage insurance premiums (MIPs). They also impose limits on the amount you can borrow.

While FHA loan interest rates are often lower than those of conventional mortgages, the inclusion of MIPs and other fees can sometimes result in higher annual percentage rates (APRs).

An FHA adjustable-rate mortgage operates similarly to other types of adjustable-rate mortgages (ARMs): Initially, the interest rate remains fixed for a specified period, then adjusts periodically until the loan is fully paid off.

These adjustments are tied to an index of prevailing interest rates — for FHA loans, typically either the Constant Maturity Treasury (CMT) index or the Secured Overnight Financing Rate (SOFR) — plus a margin. This margin is an additional amount set by the lender. When the initial fixed-rate period ends, the lender adds the margin to the index to determine the new interest rate. Depending on current economic conditions and prevailing interest rates, the adjusted rate may be higher or lower.

It’s important to note that there are caps on how much your rate can increase or decrease. ARM loans have both annual caps, which limit the rate change each year, and lifetime caps, which restrict changes over the entire term of the loan.

There are five types of FHA ARM loans available:

  • 1-year FHA ARM: The interest rate remains fixed for the first year of the loan. Afterward, the rate can increase annually by up to one percentage point, with a lifetime cap of five percentage points.
  • 3-year FHA ARM: The interest rate remains fixed for the first three years. Similar to the 1-year ARM, the rate can increase annually by up to one percentage point, with a lifetime cap of five percentage points.
  • 5-year FHA ARM: The interest rate remains fixed for the first five years. After this period, the rate can increase annually by up to one percentage point, with a lifetime cap of five percentage points. Alternatively, it can increase by two percentage points annually with a lifetime cap of six percentage points.
  • 7-year FHA ARM: The interest rate remains fixed for the first seven years. Afterward, the rate can increase annually by up to two percentage points, with a lifetime cap of six percentage points.
  • 10-year FHA ARM: The interest rate remains fixed for the first ten years. Similar to the 7-year ARM, the rate can increase annually by up to two percentage points, with a lifetime cap of six percentage points.

Additionally, FHA ARM loans can be either standard or hybrid. Standard ARM loans, like the 1-year FHA ARM, have an interest rate that adjusts regularly based on market conditions. Hybrid ARM loans have a fixed introductory rate for a specified number of years (3, 5, 7, or 10), after which the rate adjusts annually for the remaining loan term.

Borrowers and their prospective homes must meet specific qualifications for FHA loans, which include:

  • Property type: Must be a primary residence.
  • Loan limits: Up to $498,257 for a one-unit property in standard markets; up to $1,149,825 for high-cost areas.
  • Credit score: Minimum of 580, or as low as 500 with a larger down payment.
  • Debt-to-income (DTI) ratio: Up to 43% for total long-term debt, including housing costs; some lenders may accept up to 50% with compensating factors. Housing debt alone should not exceed 31%.
  • Down payment: 3.5% with a credit score of 580 or higher; 10% with a credit score between 500 and 580.
  • Employment: Verification of steady employment over the past two years.
  • Income: Latest pay stubs and evidence of additional income such as bonuses or commissions, if consistent.
  • Mortgage insurance premiums (MIP): 1.75% of the loan amount at closing, plus annual premiums based on the loan amount, down payment, and term (15 or 30 years).

For applicants with limited credit history, particularly in managing debt, FHA guidelines now allow lenders to consider rental payments in their underwriting assessment. Proof of timely rent payments for the past year is required to demonstrate responsible financial management.

ARMs typically offer lower introductory rates compared to fixed-rate loans. As of June 13, 2024, the average interest rate for 5/1 ARM loans stands at 6.48 percent, while the average rate for 30-year fixed-rate mortgages is higher at 7.08 percent, based on Bankrate’s survey of major national lenders. Even a 7/1 ARM loan carries a lower interest rate of 6.72 percent.

When evaluating FHA ARM options, it’s crucial to consider not only the introductory rate but also the lender’s margin. Generally, a lower margin is more favorable for borrowers.

Given the current trend of rising interest rates, the type of FHA ARM matters as well. For instance, one-year and three-year ARMs typically have lower caps, which means your interest rate won’t increase as drastically if market rates rise in the future.

Opting for an FHA adjustable-rate mortgage (ARM) can be advantageous if securing a lower initial interest rate is crucial for affording a home, provided you consider your capacity to manage potentially higher payments later on. It’s also suitable if you plan a short-term home ownership, benefiting from the initial lower rate and potentially selling before the rate adjusts. Alternatively, if you decide to keep the home, refinancing into a fixed-rate mortgage can maintain consistent monthly payments for the remainder of the loan term.

In some cases, anticipated future income growth, such as through a promotion or raise, might make higher future mortgage payments feasible. However, if the prospect of rate increases is unsettling, sticking with a fixed-rate mortgage might be preferable.

Pros and Cons of FHA ARM Loans:

Pros:

  • Offers appealing introductory interest rates
  • Easier qualification, particularly beneficial if credit is less than ideal
  • Facilitates earlier home ownership with lower down payment and more manageable monthly payments

Cons:

  • Risk of future rate hikes leading to unaffordable monthly payments, potentially necessitating home sale, relocation, or increasing foreclosure risk
  • Requires refinancing to eliminate mortgage insurance premiums
  • Restricted to purchasing homes within loan limits and for primary residence use

There are several alternatives to FHA ARMs that can assist you in purchasing a home:

HomeReady mortgage: Fannie Mae’s HomeReady program requires a minimum credit score of 620. It’s open to all homebuyers, not just first-timers, provided their income is below 80 percent of the area median. Completion of a homeowner’s education course is also required.

Standard 97 Home Loan: Also from Fannie Mae, this mortgage requires a 3 percent down payment, with at least one borrower being a first-time homebuyer.

HomeOne Loan: Freddie Mac offers the HomeOne Loan specifically for first-time homebuyers. It has no income or geographic restrictions, allowing a minimum down payment of 3 percent.

Home Possible Mortgage: Another option from Freddie Mac, the Home Possible mortgage is tailored for very low- to low-income homebuyers. Eligibility is based on income limits, typically set at 80 percent or less of the area median income.

These mortgage options are intended solely for primary residences. If you need financing for a second home or investment property, you’ll need to explore other avenues.

Many borrowers choose to refinance before their initial ARM rate resets. If interest rates have decreased since obtaining the loan and you prefer the stability of a fixed rate, refinancing into a fixed-rate mortgage could be beneficial. Alternatively, you could refinance into another ARM if it suits your financial strategy.

Another option is refinancing from an FHA mortgage to a conventional loan, provided you qualify. Conventional loans typically require mortgage insurance only if your equity is less than 20 percent, unlike FHA loans which require insurance for the entire loan term regardless of equity paid down. This move can help eliminate or reduce ongoing mortgage insurance costs.

However, refinancing is economically viable only if you secure a lower interest rate that justifies the closing costs. If you don’t anticipate staying in the home long enough to recover these expenses through savings, refinancing may not be financially prudent.

The considerations for choosing between an FHA adjustable-rate mortgage (ARM) and a fixed-rate mortgage mirror those for conventional loans. ARMs are ideal for homeowners who expect to sell their home within a few years, aligning with the end of the ARM’s initial fixed-rate period, or anticipate a significant income increase to handle potential rate adjustments.

Beyond these factors, the key decision revolves around determining if the additional application and appraisal requirements, along with the mandatory mortgage insurance premiums (MIP) of FHA loans, justify the potentially better terms. If the benefits outweigh these extra costs, pursuing an FHA ARM can still be a viable choice.