Adjustable-rate mortgages (ARMs) can make a lot of sense for many people. You can generally get a lower rate than you could with comparable fixed-rate loans. Additionally, if you plan on moving before the end of the initial fixed-rate period of the loan, you may never deal with an adjustment.
Today, we’re going to discuss FHA ARMs. These can be a great option if you’re looking for the flexibility of an adjustable rate, but your credit is less than perfect. We’ll touch on everything you need to know. Let’s start at the beginning.
What Is An FHA Adjustable-Rate Mortgage?
An FHA adjustable-rate mortgage is an ARM backed by the Department of Housing and Urban Development (HUD). They work like any other ARM would.
There is a period of time at the beginning of the loan during which the rate is fixed. Because people who invest in the loan know that the rate can change after the fixed period, you’ll get a lower initial rate than you could on comparable fixed-rate mortgages because they don’t have to project inflation out as far in advance.
At the end of the fixed period, the rate adjusts up or down based on an index added to a margin. In the case of FHA ARM loans, this index is the 1-year constant maturity treasury (CMT). However, there are caps and floors to how much a rate can go up or down at each adjustment.
After each adjustment, your payment is reamortized, or recalculated, to pay off at the end of your term, usually 30 years on ARM loans.
Although we’ll spend the rest of this article talking about ARMs, you can also get fixed-rate FHA mortgages of various term lengths.
What Is A 5-Year FHA Arm Loan?
With a 5-year FHA ARM, you’ll get the lowest mortgage rate we offer and save thousands over a traditional fixed-rate mortgage during the initial fixed-rate period (5 years). Once the fixed-rate period ends, your rate can change once per year.
Depending on market conditions, the change in rate could be up or down. Rate changes are capped at 5% in either direction and it can’t go up or down more than 1% per year. For example, let’s say your initial rate is 3.375%. The highest your rate can jump to is 8.375%.
The 5-year FHA ARM is a popular option offered by Rocket Mortgage® for clients who want the flexibility of an ARM but have credit scores that are a little bit lower than would qualify for a conventional loan. This FHA option allows you to qualify with a median FICO® Score of 580 or better. The only other conditions are that your housing expenses can’t total more than 38% of your gross monthly income. And your total debt-to-income ratio (DTI) can’t be higher than 45%.
If your median score is 620 or better, qualifying DTI is decided on a case-by-case basis. However, it can be as high as 67%.
It’s possible to qualify with a median credit score of 500 or better, but Rocket Mortgage doesn’t do these loans at this time.
Do You Need A Down Payment For An FHA ARM Loan?
You do need a down payment for an FHA loan, so it’s important to plan for this cost. At Rocket Mortgage, we require a minimum down payment of 3.5%.
It’s important to note that the size of your down payment affects a couple of things. For starters, the FHA has required mortgage insurance premiums (MIP). There’s a required upfront payment of 1.75% of the loan amount in addition to annual mortgage insurance premiums which are spread out over the course of 12 months on your mortgage payment. The bigger your down payment, the lower your annual premiums.
Additionally, if you make a down payment of 10% or more, mortgage insurance premiums come off after 11 years. Otherwise, you have to pay them for the life of the loan.
There are also the typical rules that apply with any loan. The bigger your down payment, the lower your monthly payment is going to be because you start with a smaller balance.
Are There Benefits To An FHA ARM Loan?
An FHA ARM loan has both its advantages and disadvantages. Let’s run through them.
Pros Of An FHA Adjustable-Rate Mortgage
There are a few potential benefits to an FHA ARM loan. Here are several of them:
- Lower initial interest rate: The interest rate you get on an ARM loan will be lower than the rates you can get on comparable fixed-rate loans because mortgage investors know that the rate can change in the future. This could allow you to pay down a lot more of your balance with the money you’re saving on the monthly payment by putting it toward the principal. This is also a good option if you think you’ll move before the rate ever adjusts.
- Caps on adjustment are lower than some other ARM offerings: The 1% limit on an initial and subsequent adjustments upward could mean that an increased rate doesn’t lead to as much of a payment shock as you might have with other loans.
- Lower payment: Because ARMs have a lower initial rate and a 30-year term, you may find that you end up with a lower payment than you might have on a fixed-rate loan, at least for the first several years.
- Modest down payment: The down payment only needing to be 3.5% is very attractive.
- Qualify even if your credit isn’t perfect: The FHA allows you to qualify for a loan even if you’re still working on your credit. You can qualify with a median score as low as 580 with most lenders. Meanwhile, a score of 620 or higher could help you qualify with more existing debt than you could on other products.
Cons Of An FHA Adjustable-Rate Mortgage
While there are numerous benefits to an FHA ARM loan, there are also drawbacks:
- Payment uncertainty: You won’t know from year-to-year what your principal and interest payment will be because of the adjustments after the fixed period. Many prefer the certainty of a fixed rate.
- Mortgage insurance premiums: There’s an upfront premium that can either be paid at closing or built into the loan. Additionally, there are annual premiums that stick around for up to the life of the loan if you don’t make a down payment of at least 10%.
- Interest rate floors: Just as there are limits to how much your interest rate can go up, there are also floors and limits to how much it can go down. Because of this, if there’s been a dramatic lower shift in interest rates, you may not be able to take full advantage.
- Possible lower loan limits: FHA loan limits are set on a county-by-county basis. In certain areas, the loan limits may be lower than what’s available for conventional loans.
The Bottom Line: See If An FHA ARM Loan Might Work For You
FHA ARMs are adjustable-rate mortgages backed by HUD. Adjustable-rate mortgages offer lower initial interest rates during their fixed period, but you need to be sure you’re comfortable with the fact that interest rates could go higher, limited by caps. However, you could also move or refinance before the rate ever adjusts in some cases.