FHA Adjustable-Rate Mortgage: What It Is And How It Works

For many families, homeownership is symbolic of the American dream. However, with inflation and rising interest rates, that dream may seem even more distant for borrowers having difficulties securing mortgage financing.

Fortunately, the Federal Housing Administration (FHA) offers an adjustable-rate mortgage (ARM), a mortgage loan with less strict financial requirements and a low introductory interest rate that can last for a decade. Here’s what you need to know about an FHA adjustable-rate mortgage to understand if one is right for you.

The FHA provides various mortgage loans with less stringent financial stipulations. Specifically, FHA loans usually don’t require as high of a credit score or as favorable of a debt-to-income ratio as conventional mortgages. These loans also generally require a small down payment (3.5%). Additionally, the federal government insures FHA loans.

An FHA adjustable-rate mortgage  consists of four components: initial interest rate period, index, margin, and interest rate cap. Investors gives borrowers an initially low interest rate on the mortgage for a fixed number of years. Then, once the introductory period expires, the mortgage interest rate fluctuates based on an index preset in the loan conditions. For FHA loans, it’s typically the Constant Maturity Treasury (CMT) and the U.S. Treasury that determine mortgage rates.

Margin refers to how much the investor increases your mortgage’s interest rate using the index as a baseline. Based on this margin and the caps and floors on interest rate movements specified in your mortgage contract,  the index determines your interest rate periodically once the introductory period is over. Because of the margin, your interest rate will always be above the index.

The interest rate cap sets an upper limit for your loan’s interest rate. For example, an ARM with an introductory period of 10 years could have a 1/1/5 limit structure. This cap structure means that after the fixed-rate period, the interest rate would not deviate more than 1% from the initial rate. Afterward, while the interest rate might change every year, your interest rate will never rise beyond 1% from the calculated rate. The final figure in the structure means that the maximum the interest rate can grow in total over the life of the loan is by 5%.  

It’s also important to note that for most investors the caps in your mortgage contract also represent interest rate floors. Just as the rate won’t go up beyond the amount specified, it won’t go down by more than that either, regardless of what the market interest rate is.

So in the above example, at the first adjustment, the rate won’t go down more than 1% or fall more than 1% with each subsequent adjustment. Over the life of your loan, the rate won’t fall more than 5%.

Yes, the FHA offers ARMs with fixed-interest periods of 1, 3, 5, 7, and 10 years.

The types of mortgages the FHA offers with adjustable rates come in variants based on the length of the initial-rate period and the allowed range of interest rates.

Standard 1-Year ARM

FHA ARMs come with an introductory period of 1 year and can increase the interest rate by 1% following the fixed-rate period, and 5% throughout the mortgage.

Hybrid ARMs

Hybrid ARMs are named as such because they often include extended initial rate periods. Though the interest rates in these ARMs will eventually change, they typically offer a fixed interest rate for a considerable amount of time. As such, they are hybrid loan products rather than strictly adjustable-rate loans. Hybrid ARMs come in the following forms:

• 3-year FHA ARMs: 3-year FHA ARMs have an initial fixed interest rate lasting 3 years. Then, the interest rate can rise by 1% per interval and no more than 5% throughout the mortgage.
• 5-year FHA ARMs: 5-year FHA ARMs offer two alternative structures: a jump of 1% per year and 5% throughout the loan, or 2% per year and a maximum of 6% throughout the loan. Either is known as a 5/1 ARM loan.
• 7-year FHA ARMs: The interest rates of 7-year FHA ARMs can rise by 2% per year and 6% throughout the loan duration.
• 10-year FHA ARMs: The interest rates of 10-year FHA ARMs can rise by 2% per year and 6% throughout the loan duration.

Rocket Mortgage^® offers FHA 5/1 ARMs at this time.

FHA ARMs have specific mortgage qualifications home buyers must meet to qualify for a loan. First, borrowers must be ready to take on a mortgage that could last 15 – 30 years. Secondly, FHA ARMs accommodate borrowers with a credit score as low as 500 but they must make a down payment of 10% of the loan value at closing. Borrowers with credit scores of 580 or higher only have to put down 3.5%. It’s important to note that the minimum credit score to obtain an FHA loan at Rocket Mortgage is 580.

Depending on your region, the FHA may finance ARMs up to $970,800. Additionally, all FHA loans charge mortgage insurance premiums (MIP) to help offset the risks of the loan. You’ll pay MIP as part of your monthly mortgage payment in addition to upfront mortgage insurance premium of 1.75% that can be paid at closing or financed into the loan.

FHA ARMs offer numerous advantages, but it’s a good idea to be mindful of additional considerations:

Pros

• The introductory period gives borrowers a rate lower than comparable fixed interest rates they might receive.
• Hybrid products help borrowers with a lengthy fixed-rate period.
• Flexible standards allow borrowers with financial difficulties and challenged credit histories to qualify.
• There’s often a low down payment requirement.
• Caps and margins help control interest rate changes.

Cons

• Adjustable interest rates can increase your monthly payment to unmanageable levels. When you qualify, it’s based on the highest your payment could never be, but your financial situation might change before the payment adjusts.
• Mortgage insurance premiums raise your monthly payment without helping you build equity.

An FHA ARM can provide significant benefits if you plan on owning your home for just a few years before selling or can pay off the loan during the fixed-rate period. Borrowers who can take advantage of the low initial interest rate by paying down their loan before the rate adjusts have the opportunity to save possibly thousands of dollars through an FHA ARM.

Additionally, borrowers with less-than-ideal financial circumstances may find FHA ARMs helpful. The standards allow borrowers who can’t access other mortgage loan products to get a mortgage and become homeowners.

Another advantage an FHA ARM presents is the opportunity to refinance the loan to a fixed-rate mortgage before the initial rate expires. This way, borrowers looking to save money could purchase a home with an FHA ARM, then refinance to a mortgage with a permanent interest rate. Of course, this assumes fixed rates haven’t increased substantially and that you qualify to refinance.

FHA ARMs are mortgage loan products offering an array of benefits to many prospective homeowners, particularly those who face financial challenges. A wider range of borrowers qualifes for FHA ARMs, allowing individuals and families with less income to become homeowners. Additionally, the low interest rate of an FHA ARM can last for up to 10 years, giving borrowers ample time to refinance or pay off the loan before the interest rate jumps.

If you’re interested in an ARM to finance your home, start your application with Rocket Mortgage today. You can also give us a call at (833) 326-6018.