Are you ready to purchase a home but worry you may not qualify for a mortgage? Have you considered the FHA’s adjustable-rate mortgage (ARM)? The FHA ARM (which is insured by the Federal Housing Administration) may be the loan that makes your home buying dreams a reality.
The credit score and down payment requirements for FHA ARMs are more relaxed than many conventional mortgages. And their initial interest rates are typically lower than FHA mortgage loan fixed rates, making them an attractive option for first-time home buyers or buyers struggling to meet conventional mortgage requirements.
But before you fully embrace an FHA ARM, weigh its pros and cons and learn how it works to make sure it’s a loan option you can make work for you.
What Is an FHA ARM Loan?
First, a quick refresher: FHA loans are government-backed loans. The government promises lenders it will cover the loan if a borrower defaults. This promise allows lenders to offer mortgages to home buyers who may not qualify for a conventional loan.
The key difference between a standard FHA mortgage loan and an FHA ARM is the interest rate: Is the rate fixed or adjustable?
Standard FHA loans offer borrowers a fixed interest rate over the life of the loan. The interest rate is locked in. Your principal payment and interest payment stay the same month to month.
ARM loans have four major components:
Depending on the FHA ARM you select, you’ll get a lower introductory interest rate for 1, 3, 5, 7 or 10 years. When the introductory period ends, your rate will adjust based on market interest rates (think: increase or decrease) once a year.
FHA ARM interest rates adjust annually based on the Constant Maturity Treasury (CMT) rate set by the U.S. Treasury.
At the end of the introductory period, your interest rate will adjust annually. Conventional ARM loans can adjust as often as every 6 months or as infrequently as every 5 years.
Interest rate caps
ARM loans also include interest rate caps. Your interest rate will be capped in two ways: annually and over the life of the loan.
For example, with a standard 1-year FHA ARM, during the adjustment period, the interest rate can’t increase more than 1% a year and never more than 5% over the life of the loan.
If you took out an FHA ARM with a 4.5% interest rate, your interest rate could jump to 5.5% in year 2. If interest rates continue to climb, you’ll never pay more than 9.5% in interest.
What Are the Different Types of FHA ARM Loans?
There’s an FHA loan for every type of borrower. FHA ARM loans can range from a 1-year standard ARM to hybrid ARMs.
Standard 1-year FHA ARM
As the name suggests, the loan has a fixed interest rate for the first year. After that, the interest rate will adjust every year based on market rates.
Annually, the maximum the interest rate can increase is 1%. Over the life of the loan, the interest rate increase won’t ever go higher than 5%.
A hybrid FHA ARM combines a longer fixed-rate introductory period with the annual rate adjustment of a standard 1-year FHA ARM. The available hybrid ARM terms are:
- 3/1 FHA ARM: The initial interest rate is fixed for the first 3 years and then adjusts annually. The interest rate adjustment is capped at 1% annually and 5% over the life of the loan.
- 5/1 FHA ARM: The initial interest rate is fixed for the first 5 years and then adjusts annually. There are two interest rate adjustment options. Option one: The interest rate adjustment is capped at 1% annually and 5% over the life of the loan. Option two: The interest rate adjustment is capped at 2% annually and 6% over the life of the loan.
- 7/1 and 10/1 FHA ARM: For both loans, the interest rate is fixed for the first 7 or 10 years. After that, the interest rate can’t increase more than 2% annually and 6% over the life of the loan.
How Much Can You Borrow With an FHA ARM?
The amount you can borrow with an FHA loan will depend on the county where you’re buying the home and the type of property you’re purchasing.
In low-cost areas, you can borrow up to the FHA floor, which is $420,680, or 65% of the national conforming loan limit of $647,200. In high-cost areas, you can borrow up to the FHA ceiling – which is 150% of the national conforming loan limit, or $970,800.
What Are the Requirements for an FHA ARM?
To qualify for an FHA ARM, you must meet the same basic requirements you’d need to meet for an FHA loan. Lenders will require a steady income, a qualifying credit score and a down payment of up to 3.5% or 10% depending on your credit score.
You’ll need to prove you have enough money saved to continue making your monthly mortgage payments even if interest rates rise. In addition to your income and credit history, your lender will review your employment history, debt and other financial obligations.
Here’s a breakdown of the specific requirements for an FHA ARM:
- Credit score: To qualify for an FHA ARM loan with a 3.5% down payment, you’ll need a credit score of 580 or higher. If you have a credit score as low as 500, you’ll need to make at least a 10% down payment.
- Debt-to-income (DTI) ratio: The amount you pay on your monthly fixed debts shouldn’t eat up more than 43% of your gross monthly income. This includes your mortgage, credit cards, car loans, student loans, etc.
- Primary residence requirement: The home you purchase must be your primary residence to qualify for an FHA ARM. Investment properties and second homes don’t qualify.
Pros and Cons of an FHA ARM Loan
While an FHA ARM may seem tempting at first glance, you should consider the loan’s pros and cons before you make any decisions. Here’s a look at some of the advantages and disadvantages of an FHA ARM:
✅Low initial interest rate
You may be able to secure a lower initial interest rate with an FHA ARM than a fixed-rate FHA mortgage.
✅Lower credit score requirement
You can qualify for an FHA ARM loan with a credit score as low as 500. For a conventional loan, you’ll need a credit score of at least 620.
✅Interest rate caps
FHA ARM loans come with annual and lifetime interest rate caps, which protect you from big spikes in your monthly payments.
⛔Potential for higher monthly payments
While your monthly payments will be lower initially, they could increase significantly after the introductory fixed-rate period ends.
⛔Can be difficult to refinance
If interest rates get so high that it makes your monthly mortgage payments unaffordable, it may be difficult to refinance to a more affordable loan with a lower interest rate.
⛔Mortgage insurance requirement
All FHA loans require upfront and annual mortgage insurance premiums (MIPs). While the premiums add to the cost of the loan, they won’t help you build equity because your payments aren’t applied to the loan’s principal.
Making Home Buying Possible
Whether you’re a first-time home buyer or a seasoned real estate vet, an FHA ARM loan offers all the perks of an FHA loan (a lower down payment, more relaxed credit requirements, etc. ) at an even lower interest rate.
But that lower initial rate won’t last forever, so you’ll need a plan to stay in your home when the rate adjusts.