What is an FHA ARM Loan?
An FHA ARM loan is an adjustable-rate mortgage (ARM) backed by the Federal Housing Administration (FHA). ARM loans offer a lower interest rate and monthly payment for the first few years of the mortgage, but then the initial fixed rate converts to an adjustable rate, which rises and falls with the market as a whole. FHA ARM loans can offer some relief from high interest rates but also come with risks once the interest rate changes.
How does an FHA ARM loan work?
FHA ARM loans come in two types: standard and hybrid. With a standard ARM loan, your interest rate adjusts at regular intervals based on changes in the market.
A hybrid ARM is similar but adds an initial fixed-rate period before the later period when the ARM adjusts. With hybrid ARMs, you can tell how long the initial period is from the name of the loan: A 5/1 ARM, for instance, has an initial period of five years, after which the rate will adjust once per year.
For all ARM loans, it’s important to understand that “adjusting” means that the interest rate will change and that this can in turn change how much you’ll owe on your next bill.
The appeal of an ARM loan is:
Saving money
During the initial fixed-rate period, you’ll likely be paying an interest rate below what you’d pay on a 30-year fixed-rate loan. This can save you money if you’re going to sell the home before the ARM begins adjusting.
Qualifying for a bigger loan
For many borrowers, an ARM means the ability to get into a more expensive home than they could get with a fixed-rate loan. As a result of the initial low rate and low monthly payment, borrowers may be able to purchase “more house” with an ARM.
However, because that rate could increase once the initial fixed period is over, continuing to make a higher monthly payment may become more difficult over time.
FHA ARM loan vs. FHA fixed-rate mortgage
The FHA offers both fixed- and adjustable-rate loans. FHA loans are intended to help homebuyers who may not qualify for conventional loans due to low credit, limited down payment funds or other issues in their financial profiles.
Types of FHA ARM loans
There are several types of FHA ARM loans available:
| FHA ARM loan type | Rate cap structure | |
|---|---|---|
| May increase annually during adjustment period up to | May increase over the life of the loan up to | |
| Standard 1-year | 1 percentage point | 5 percentage points |
| Hybrid 3-year | 1 percentage point | 5 percentage points |
| Hybrid 5-year | 1-2 percentage points | 5-6 percentage points |
| Hybrid 7-year | 2 percentage points | 6 percentage points |
| Hybrid 10-year | 2 percentage points | 6 percentage points |
The Consumer Financial Protection Bureau (CFPB) recommends not taking out any ARM loan whose highest possible monthly payments you can’t afford. Don’t assume that the loan won’t adjust up to the maximum interest rate. If you need help calculating what an ARM loan’s highest payment might be, use an ARM calculator.
FHA ARM loan interest rates
ARM rates are generally lower than rates on 30-year fixed-rate mortgages during the initial period. In the last quarter of 2022, for example, 5/1 ARM rates were 0.672 percentage points lower than rates on 30-year fixed-rate mortgages.
Calculating FHA arm rates is a little bit more complicated than calculating other mortgage rates. ARM interest rates are calculated using four main elements that you should know about: an index, a margin, a rate cap and a rate floor. Here’s how they work:
Index
When ARM rates adjust, they are calculated based on an index, which is a benchmark interest rate that changes as economic conditions change. Which index, exactly, your loan’s rates will depend on is decided by the lender and will be stated in your loan estimate.
Margin
Each time your loan adjusts, the lender will add a number called a margin to the index rate.
Interest rate caps and floors
The interest rate on an adjustable-rate mortgage must stay within a certain window, which limits how high the rate can adjust up (a rate “cap”), as well as how low it can adjust down (a rate “floor”). These limits protect borrowers against extreme cost increases and lenders against ultralow interest rates that would make issuing the loan a losing proposition.
FHA ARM loan requirements
As with all mortgage loans, you will need to go through the process of applying and qualifying for an FHA ARM loan. This ranges from getting your finances in order to finding the right lender and making sure you meet any loan requirements.
Credit history. Although credit score requirements vary by lender, the FHA does guarantee loans for borrowers with a credit score as low as 500. Check your credit score and make sure all of the information on your credit report is correct.
Down payment. All FHA loans offer a relatively low down payment requirement, but keep in mind that if your credit score is weak, you’ll have to make up for it with a bigger down payment. Borrowers with a credit score of 580 or higher can put only 3.5% down, while those with a credit score between 500 and 579 will have to put 10% down.
DTI ratio. Lenders will look at your debt-to-income (DTI) ratio to see if you can afford to pay your mortgage. They determine your DTI by adding up your monthly debt payments and dividing that by your gross monthly income.
Cash reserves. If your credit is below 580 or your DTI is above 43%, you may be required to show that you have a certain amount of cash on hand to cover any house-related expenses that might come up.
Mortgage insurance. FHA loans require two types of mortgage insurance, a one-time, upfront mortgage insurance premium (UFMIP) and an ongoing annual mortgage insurance premium (MIP). If your down payment is less than 10%, you’ll pay your MIP for the entire loan term, but if you put at least 10% down, you’ll stop paying your MIP after 11 years.
Property type. An FHA loan can only be used to finance a primary residence, meaning you have to live there for at least 12 months.
Pros and cons of an FHA ARM loan
Pros
Low rates. The low initial interest rates ARMs offer can help you afford a more expensive home than you could qualify for with a higher rate. This lower rate could also mean a lower monthly payment, allowing you to save money or put your resources toward other financial goals.
An affordable down payment. You may be able to qualify with a down payment as low as 3.5% if you have a minimum credit score of 580.
Flexible credit requirements. Individual lenders will set their own requirements for minimum credit scores, but the FHA will guarantee loans with a minimum credit score of 500.
Protection from excessive rate increases. Although the interest rate will increase once the initial fixed-rate period ends, the rate can’t increase by more than 1 to 2 percentage points each year. It also can’t increase by more than 5 to 6 percentage points for the life of the mortgage loan.
Cons
High monthly payments. Because the rate will fluctuate after the fixed-rate period ends, it could go up. If it does, your monthly payment also could increase — potentially to the point that it is no longer affordable for you.
Mortgage insurance. When you receive an FHA ARM loan, you will have to pay an upfront mortgage fee of 1.75% of the loan amount to insure the loan. During the loan term, you’ll also have to pay an annual mortgage insurance premium (MIP).
Loan limits. FHA ARM loan limits are typically lower than those of a conventional mortgage, which means they could be too low to cover the cost of a home where you live.
When is an FHA ARM loan a good idea?
→ You don’t plan to keep the home very long
If you know you’ll be moving soon, you could take advantage of an FHA ARM loan’s initial low rate. If you sell your home before the rate begins to adjust, you could come out with significant savings over using a 30-year fixed-rate mortgage.
→ You want to pay off your mortgage early
Because you’ll have a fixed lower rate at the beginning of your FHA ARM loan term, you could choose to make extra payments in order to pay down the loan principal faster. That would not only help you pay off your mortgage sooner but could also save you thousands of dollars in interest.
→ You can pay for the loan even if the rate increases
It’s important to understand just how much your FHA ARM loan will cost over the full term of the mortgage. Ask your lender what the maximum monthly loan payment could be for your loan. If you could afford it, an FHA ARM loan could be right for you.
→ You want to buy a home while rebuilding your credit
Because you can qualify for an FHA ARM loan with a lower credit score than conventional loan requirements demand, you could go ahead and buy a house now instead of waiting while you rebuild your credit.
→ You’re expecting a pay raise
If you see a raise in your near future, getting an FHA ARM loan could be a good fit because you’ll be able to afford the monthly payments now and later when the interest rate may increase.
How to refinance an FHA ARM loan
If you want to avoid the risk of your ARM adjusting to an unaffordably high interest rate, you can refinance before the ARM’s initial fixed-rate period ends. You can refinance into another ARM or, if you’re able to meet the credit and other requirements, into a fixed-rate conventional loan.
If you don’t want to pay mortgage insurance until you own your house outright, which is often required with FHA loans, you should consider refinancing into a conventional loan. You may still have to pay mortgage insurance at first — assuming you don’t yet have 20% equity in the home — but you won’t be locked into it for the life of the loan. Once you reach 20% equity, you can get rid of that pesky mortgage insurance line item on your monthly payments.