Guide to FHA adjustable-rate mortgages

2023-07-17 11:18:01 • 113 Views

FHA loans — those Federal Housing Administration-backed mortgages whose generous terms make homeownership accessible to many borrowers — come with either a fixed or adjustable interest rate. The latter offers a lot of benefits, centered around its low introductory rate. But before signing on the dotted line for an FHA loan with an adjustable rate, it’s important to know what’s involved and how these types of mortgages work.

Here are the basics of FHA adjustable-rate mortgages (ARMs).

Key takeaways

FHA adjustable-rate mortgages (ARMs) offer a low initial interest rate that lasts three to seven years
Once the introductory period ends, the interest rate can move up or down every six months to one year
Because the monthly mortgage payment goes up when the interest rate increases, qualifying for an ARM typically requires the ability to make a higher mortgage payment
While an adjustable-rate mortgage (ARM) typically has a lower introductory rate, it isn't without risk

Adjustable-rate mortgage (ARM) overview

An adjustable-rate mortgage, or ARM, is a type of home loan with an interest rate that changes over time. ARMs have a lower, fixed rate at the start of the repayment period, which usually last three, five or seven years. Afterward, the rate can move up or down at predetermined intervals, such as every six months or one year, up to a certain percentage limit. This means your monthly mortgage payment could increase or decrease over the remaining loan term. If the payment goes up, it might no longer be affordable. For this reason, lenders typically qualify ARM borrowers based on their ability to repay a higher payment.

FHA loans overview

FHA home loans are insured by the Federal Housing Administration (FHA) and offered by FHA-approved mortgage lenders, which range from bricks-and-mortar banks to online lenders companies. These loans are geared toward lower-credit score borrowers, including first-time homebuyers, who often wouldn’t qualify for a conventional loan (one that has no federal guarantee). FHA loans only require 3.5 percent of the home’s price as a down payment, but also require the borrower to pay mortgage insurance premiums (MIPs), and impose a limit on how much can be borrowed. FHA loans tend to offer lower interest rates than conventional mortgages too, but sometimes the presence of their various fees (including the MIP) actually make their APRs higher.

How do FHA ARM loans work?

An FHA ARM loan works similar to other adjustable-rate mortgages in that the interest rate remains the same for a period of time, then changes at preset times until the borrower fully repays the loan.

These changes are based on an index of prevailing interest rates — for FHA loans, either the Constant Maturity Treasury (CMT) index or the Secured Overnight Financing Rate (SOFR) — plus a margin, or extra amount, that the lender opts to add on. After the loan’s initial fixed period ends, the lender adds their margin to the index to come up with new rates. Depending on current economic conditions and prevailing interest rates, the adjusted rate might be higher or lower.

Your rate can’t increase or decrease beyond a specific amount, however. On ARM loans, there are both annual and lifetime caps — upper and lower limits on rate changes on a yearly basis as well as for the duration of the loan’s term.

Types of FHA ARM loans

There are five kinds of FHA ARM loans:

1-year FHA ARM: Your interest rate stays the same for the first year of the loan’s term. After that, the rate can only increase by one percentage point (for example, 5.5 percent to 6.5 percent) per year and five percentage points for the life of the loan.
3-year FHA ARM: Your interest rate stays the same for the first three years, but the caps are the same as the 1-year ARM.
5-year FHA ARM: Your interest rate stays the same for the first five years. After that, the rate can only increase annually by one percentage point, and by five percentage points over the life of the loan; or by two percentage points annually and six percentage points over the life of the loan.
7-year FHA ARM: Your interest rate stays the same for the first seven years, then can adjust by up to two percentage points per year and six percentage points over the life of the loan.
10-year FHA ARM: Your interest rate stays the same for the first 10 years, but the caps are the same as the 7-year ARM.

Acceptable properties: Primary residences
Borrowing limit: $472,030 for a one-unit property; $1,089,300 for a one-unit property in high-priced housing markets
Credit score: At least 580, or as low as 500 with a bigger down payment
Debt-to-income (DTI) ratio: 43% for housing and other long-term debt (some lenders may go up to 50% if borrower has compensating factors); 31% for just housing debt.
Down payment: 3.5% with a credit score of 580 or higher; 10% with a credit score of 500-580
Employment: Proof of steady employment from the past two years
Income: Latest pay stub along with proof of any bonuses, commissions, etc., if consistent
Mortgage insurance premiums (MIP): 1.75% of amount borrowed at closing, plus annual premiums based on amount borrowed, down payment and loan term (15 or 30 years)

If your credit history is lacking, especially in the realm of handling debt, the FHA now allows lenders to include a borrower’s rental payments in their underwriting assessment, as well. You need to be able to show proof you’ve paid your rent on time every month for the past year.

FHA ARM loan rates

ARMs’ introductory rates tend to be lower than those of fixed-rate loans. As of mid-July 2023, ARM rates on Bankrate averaged just slightly lower than those of fixed-rate loans.

When comparing FHA ARM offers, consider the introductory rate along with the lender’s margin. Generally speaking, the lower the margin, the better.

With rates rising, consider the type of FHA ARM, as well. The one-year and three-year ARMs, for example, have lower caps, meaning you won’t see as big of a jump in your rate if prevailing rates do go up in the future.

Pros and cons of FHA ARM loans

Pros

Attractive introductory interest rates
Easier to qualify for if your credit needs work
Gets you into a home sooner thanks to a lower down payment and more affordable monthly payment

Cons

Risk of future increases to rate, which can make monthly payments unaffordable, potentially forcing you to sell the home and move or increasing your risk for foreclosure
Need to refinance to remove mortgage insurance premiums
Limited to buying a home with a mortgage within loan limits and for use as primary residence

Refinancing an FHA ARM

Many borrowers refinance before the first ARM rate reset. You might want to refinance out of an ARM loan into a fixed-rate one if rates have dropped since you first obtained the loan and you want the stability of an non-fluctuating rate. You can also refinance to another ARM.

If you qualify, you might want to refinance from an FHA mortgage to a conventional loan, too. This allows you to eliminate (or work toward eliminating) mortgage insurance premiums, as conventional loans only require insurance if you have less than 20 percent equity in your home. In contrast, most FHA loans require you to pay insurance for the entire loan term, regardless of how much you’ve paid down on the mortgage.

Keep in mind, refinancing is typically only worthwhile if you can get a lower rate and pay the closing costs. If you won’t be in the home long enough to recoup those costs and realize the savings, it might not make financial sense to refinance.

Bottom line on FHA adjustable-rate mortgages

The considerations for getting a FHA adjustable-rate mortgage, vs a fixed-rate one, are pretty similar to the considerations for their conventional loan cousins. ARMs work best for homeowners who are pretty sure they’ll be leaving their home within a certain number of years (coinciding with the end of the ARM’s fixed-rate period, or before) or who anticipate a big increase in income (because the ARM’s new, reset rate often means higher repayments).

Other than that, your main decision is whether it’s worth jumping through the extra application/appraisal hoops and paying the MIP that comes with FHA loans. If the better terms still seem worth it, then go for it.

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