FHA loans, backed by the Federal Housing Administration, are designed to make homeownership more accessible with their favorable terms. These loans are available with both fixed and adjustable interest rates.
FHA adjustable-rate mortgages (ARMs) are less common, with adjustable rates accounting for less than 1 percent of FHA loans originated in April 2024, according to federal data. However, FHA ARMs offer several benefits, including a low introductory rate.
Before committing to an FHA adjustable-rate mortgage (ARM), it’s crucial to understand the details and mechanics of these loans. Here’s a rundown of the essentials of FHA ARMs.
What is an FHA adjustable-rate mortgage?
Here’s a quick overview of how adjustable-rate mortgages (ARMs) and FHA loans operate:
An adjustable-rate mortgage (ARM) is a home loan with an interest rate that fluctuates over time. Initially, it offers a lower fixed rate for a set period—typically three, five, seven, or ten years. After this introductory period, the rate adjusts at predetermined intervals, such as every six months or annually, within specified limits. As a result, your monthly mortgage payment can increase or decrease throughout the remainder of the loan term. If payments rise significantly, they might become unaffordable. Consequently, lenders often qualify ARM borrowers based on their ability to handle potential higher payments.
FHA loans, insured by the Federal Housing Administration (FHA) and provided by FHA-approved lenders, are designed to assist lower-credit score borrowers and first-time homebuyers who might not qualify for conventional loans without federal backing. FHA loans require only a 3.5 percent down payment but include mandatory mortgage insurance premiums (MIPs) and have borrowing limits.
While FHA loan rates are often lower than those of conventional mortgages, the additional fees, including MIPs, can result in a higher annual percentage rate (APR).
How do FHA ARM loans work?
An FHA adjustable-rate mortgage (ARM) functions like other ARMs: it starts with a fixed interest rate for a specified period, then adjusts at regular intervals for the remainder of the loan term.
The adjustments are based on an index of prevailing interest rates—such as the Constant Maturity Treasury (CMT) index or the Secured Overnight Financing Rate (SOFR)—plus a margin determined by the lender. Once the initial fixed-rate period ends, the lender adds this margin to the index to determine the new rate. Depending on economic conditions and current rates, your adjusted rate may increase or decrease.
However, there are limits to how much your rate can change. FHA ARMs include both annual caps, which restrict how much the rate can change each year, and lifetime caps, which set a maximum rate change over the life of the loan.
Types of FHA ARM loans
There are five types of FHA adjustable-rate mortgage (ARM) loans:
- 1-Year FHA ARM: The interest rate remains fixed for the first year. After that, the rate can increase by up to one percentage point annually (e.g., from 5.5% to 6.5%) and by up to five percentage points over the life of the loan.
- 3-Year FHA ARM: The interest rate stays fixed for the first three years. After that, rate adjustments follow the same caps as the 1-Year FHA ARM.
- 5-Year FHA ARM: The interest rate is fixed for the first five years. Afterward, the rate can increase by up to one percentage point per year and by up to five percentage points over the life of the loan. Alternatively, it can increase by two percentage points annually and up to six percentage points over the loan’s term.
- 7-Year FHA ARM: The interest rate remains fixed for the first seven years. After that, it can adjust by up to two percentage points per year and by up to six percentage points over the life of the loan.
- 10-Year FHA ARM: The interest rate is fixed for the first ten years. After this period, the rate adjustments are subject to the same caps as the 7-Year FHA ARM.
Additionally, FHA ARMs come in two categories:
- Standard ARM: This type has an interest rate that adjusts regularly based on market conditions.
- Hybrid ARM: This type features a fixed introductory rate for a specified number of years (3, 5, 7, or 10). After the initial fixed period, the rate adjusts periodically for the remainder of the loan term.
FHA ARM loan requirements
To qualify for an FHA loan, both the borrower and the property must meet specific requirements:
- Property Type: Must be a primary residence.
- Borrowing Limits: For 2024, the limit is $498,257 for a one-unit property, or up to $1,149,825 in high-priced markets.
- Credit Score: Minimum of 580, though it can be as low as 500 with a larger down payment.
- Debt-to-Income Ratio (DTI): 43% for total debt (some lenders may accept up to 50% with compensating factors) and 31% for housing debt alone.
- Down Payment: 3.5% if your credit score is 580 or higher; 10% if your score is between 500 and 579.
- Employment: Proof of steady employment for the past two years.
- Income Verification: Latest pay stubs and evidence of consistent bonuses or commissions.
- Mortgage Insurance Premiums (MIP): 1.75% of the loan amount due at closing, plus annual premiums based on the loan amount, down payment, and loan term (15 or 30 years).
If your credit history is less than stellar, the FHA now permits lenders to include rental payment history in their underwriting process. You will need to provide proof of timely rent payments for the past year.
FHA ARM loan rates
Adjustable-rate mortgages (ARMs) typically offer lower introductory rates compared to fixed-rate loans. For example, as of June 13, 2024, the average interest rate for a 5/1 ARM is 6.48%, while a 30-year fixed-rate mortgage averages 7.08%, according to Bankrate’s survey of major lenders. Even a 7/1 ARM has an average rate of 6.72%.
When evaluating FHA ARM offers, it’s important to consider both the introductory rate and the lender’s margin. Generally, a lower margin is more favorable.
Given the rising interest rates, it’s also wise to consider the type of FHA ARM you choose. For instance, one-year and three-year ARMs typically have lower caps, which means less dramatic increases in your rate if market rates rise in the future.
Should you get an FHA adjustable-rate mortgage?
If a lower initial interest rate will help make homeownership more affordable, an FHA adjustable-rate mortgage (ARM) could be a good choice—provided you’re prepared for the possibility of higher payments later. FHA ARMs are also advantageous if you plan to own your home for just a few years, as you can benefit from the lower introductory rate and sell the home before the rate adjusts. If you decide to stay in your home, you might also have the option to refinance into a fixed-rate mortgage, stabilizing your payments for the remainder of the loan term.
Additionally, if you anticipate future financial improvements, such as a raise or promotion, which could make higher payments manageable, an FHA ARM might work for you. However, if the thought of potentially higher rates makes you uncomfortable, it may be better to choose a fixed-rate mortgage instead.
Pros and cons of FHA ARM loans
Pros:
- Attractive introductory interest rates
- Easier to qualify for, especially with less-than-perfect credit
- Lower down payment and more affordable monthly payments can help you buy a home sooner
Cons:
- Risk of future rate increases could make payments unaffordable, potentially leading to selling the home or increasing foreclosure risk
- Requires refinancing to remove mortgage insurance premiums
- Limited to homes within FHA loan limits and must be used as a primary residence
Alternatives to FHA ARM loans
An FHA mortgage isn’t your only option. Here are some alternatives that might help you buy a home:
HomeReady Mortgage: Offered by Fannie Mae, this program requires a minimum credit score of 620. It’s available to both first-time and repeat homebuyers, though your income must be below 80% of the area median income. Additionally, you’ll need to complete a homeowner’s education course.
Standard 97 Home Loan: Also from Fannie Mae, this mortgage requires just 3% down. One of the borrowers must be a first-time homebuyer.
HomeOne Loan: Freddie Mac’s HomeOne Loan is designed for first-time homebuyers and has no income or geographic limits. It requires a minimum down payment of 3%.
Home Possible Mortgage: This Freddie Mac option is intended for very low- to low-income buyers. To qualify, your income must be at or below 80% of the area median income.
Note that these mortgages are for primary residences only, so you’ll need other options if you’re looking to finance a second home or investment property.
Refinancing an FHA ARM
Many borrowers choose to refinance before their ARM’s initial rate adjustment. If interest rates have dropped since you took out your ARM and you prefer the stability of a fixed rate, refinancing into a fixed-rate mortgage might be a good option. Alternatively, you can refinance into another ARM if it better suits your needs.
If you qualify, consider refinancing from an FHA mortgage to a conventional loan. This switch can help you eliminate or work towards eliminating mortgage insurance premiums. Conventional loans require insurance only if you have less than 20% equity in your home, while FHA loans typically require insurance for the entire loan term, regardless of your equity.
Keep in mind that refinancing is usually only beneficial if you can secure a lower interest rate and cover the closing costs. If you won’t be in your home long enough to offset these costs and benefit from the savings, refinancing might not be the best financial move.
In Conclusion
Choosing between an FHA adjustable-rate mortgage (ARM) and a fixed-rate mortgage involves considerations similar to those for conventional loans. ARMs are typically a better fit for homeowners who plan to move within a few years (matching the end of the ARM’s fixed-rate period or sooner) or who expect a significant increase in income, as the reset rate on an ARM may lead to higher payments.
Beyond that, you need to weigh whether the benefits of FHA loans, such as potentially better terms, outweigh the additional application and appraisal requirements and the mortgage insurance premiums (MIP) associated with FHA loans. If the terms still seem advantageous despite these factors, an FHA ARM might be a suitable choice for you.