Guide to FHA adjustable-rate mortgages

FHA loans have made their mark as Federal Housing Administration-insured mortgages whose generous terms make homeownership accessible to many borrowers. They come with either a fixed or adjustable interest rate.

The latter, known as FHA ARMs, are very much a niche product – less than 1 percent of FHA loans originated in April 2024 had adjustable rates, according to federal data. But they offer a lot of benefits, particularly a low introductory rate.

Before signing on the dotted line for an FHA adjustable-rate mortgage (ARM), however, it’s important to know what’s involved and how these types of mortgages work.  Here are the basics of FHA ARMs.

What is an FHA adjustable-rate mortgage?

First, here’s a quick primer on how ARMs and FHA loans work.

An adjustable-rate mortgage, or ARM, is a type of home loan with an interest rate that changes over time. It has a lower fixed rate at the start of the repayment period, which usually lasts three, five, seven or 10 years. Afterward, the rate adjusts at predetermined intervals, such as every six months or one year, up to a certain percentage limit. This means your monthly mortgage payment could increase or decrease over the remaining loan term. If the payment goes up, it might no longer be affordable. For this reason, lenders typically qualify ARM borrowers based on their ability to repay a higher payment.

FHA home loans are insured by the Federal Housing Administration (FHA) and offered by FHA-approved mortgage lenders. These loans are geared toward lower-credit score borrowers, including first-time homebuyers, who often wouldn’t qualify for a conventional loan with no federal guarantee. FHA loans only require a 3.5 percent down payment but mandate the borrower to pay mortgage insurance premiums (MIPs). They also limit how much you can borrow.

FHA  loan rates often run lower than conventional mortgages too, but sometimes the presence of their various fees (including the MIPs) actually makes their APRs higher.

How do FHA ARM loans work?

An FHA adjustable-rate mortgage works similarly to other adjustable-rate mortgages: The interest rate initially remains the same for a set time, then changes at preset times until the borrower fully repays the loan.

These changes are based on an index of prevailing interest rates — for FHA loans, either the Constant Maturity Treasury (CMT) index or the Secured Overnight Financing Rate (SOFR) — plus a margin, or extra amount, that the lender opts to add on. After the loan’s initial fixed period ends, the lender adds this margin to the index to come up with new rates. Depending on current economic conditions and prevailing interest rates, the adjusted rate might be higher or lower.

Your rate can’t increase or decrease beyond a specific amount, however. On ARM loans, there are both annual and lifetime caps, which limit annual rate changes, as well as changes over the loan’s entire term.

Types of FHA ARM loans

There are five kinds of FHA ARM loans:

• 1-year FHA ARM: Your interest rate stays the same for the first year of the loan’s term. After that, the rate can only increase by one percentage point (for example, 5.5 percent to 6.5 percent) per year and five percentage points for the life of the loan.
• 3-year FHA ARM: Your interest rate stays the same for the first three years, but the caps are the same as the 1-year ARM.
• 5-year FHA ARM: Your interest rate stays the same for the first five years. After that, the rate can only increase annually by one percentage point, and by five percentage points over the life of the loan; or by two percentage points annually and six percentage points over the life of the loan.
• 7-year FHA ARM: Your interest rate stays the same for the first seven years, then can adjust by up to two percentage points per year and six percentage points over the life of the loan.
• 10-year FHA ARM: Your interest rate stays the same for the first 10 years, but the caps are the same as the 7-year ARM.

There is also a difference between standard and hybrid ARM loans. The FHA has a one-year standard ARM loan, whose interest rate changes regularly based on the market. In addition, the FHA has four hybrid ARM loan products. These hybrid loans have a fixed introductory rate for a set number of years (3, 5, 7 or 10), after which the rate will adjust after a set period for the remainder of the loan term.

FHA ARM loan requirements

Borrowers and the homes they wish to buy must meet certain FHA loan qualifications, including:

• Acceptable properties: Primary residences
• Borrowing limit: For 2024, $498,257 for a one-unit property; $1,149,825 for a one-unit property in high-priced housing markets
• Credit score: At least 580, or as low as 500 with a bigger down payment
• Debt-to-income (DTI) ratio: 43 percent for housing and other long-term debt (some lenders may go up to 50 percent if the borrower has compensating factors); 31 percent for just housing debt.
• Down payment: 3.5 percent with a credit score of 580 or higher; 10 percent with a credit score of 500-580
• Employment: Proof of steady employment from the past two years
• Income: Latest pay stub along with proof of any bonuses, commissions, etc., if consistent
• Mortgage insurance premiums (MIP): 1.75 percent of the amount borrowed at closing, plus annual premiums based on the amount borrowed, down payment and loan term (15 or 30 years)

If your credit history is lacking, especially in the realm of handling debt, the FHA now allows lenders to include a borrower’s rental payments in their underwriting assessment, as well. You need to be able to show proof you’ve paid your rent on time every month for the past year.

FHA ARM loan rates

ARMs’ introductory rates tend to be lower than those of fixed-rate loans. As of June 13, 2024, the average interest rate for 5/1 ARM loans is 6.48 percent, compared to the average rate of 30-year fixed-rate mortgages at 7.08 percent, according to Bankrate’s survey of national large lenders. Even a 7/1 ARM loan has an interest rate of 6.72 percent.

When comparing FHA ARM offers, consider the introductory rate along with the lender’s margin. Generally speaking, the lower the margin, the better.

With rates rising, consider the type of FHA ARM, as well. The one-year and three-year ARMs, for example, have lower caps, meaning you won’t see as big of a jump in your rate if prevailing rates do go up in the future.

Should you get an FHA adjustable-rate mortgage?

If getting a lower initial interest rate will help you afford a home, choosing an FHA adjustable-rate mortgage can be a good option — as long as you factor in your ability to afford potentially higher payments later. An FHA ARM loan can also be a smart option if you only plan to own your home for a couple of years. You can take advantage of the lower introductory rate and then sell your home before the rate adjusts. Even if you do not sell your home, you might be able to refinance your loan into a fixed-rate mortgage, which will keep your monthly payments the same for the remainder of the loan term.

There might also be some instances where you expect you’ll be able to afford a higher payment in the future. For example, a future raise or promotion could mean an increase in earnings, enabling you to afford a higher mortgage payment later. However, if the prospect of a higher rate in the future is scary to you, then you should skip the ARM and opt for a fixed-rate mortgage.

Pros and cons of FHA ARM loans

Pros

• Attractive introductory interest rates
• Easier to qualify for if your credit needs work
• Gets you into a home sooner thanks to a lower down payment and more affordable monthly payment

Cons

• Risk of future increases to your rate, which can make monthly payments unaffordable, potentially forcing you to sell the home and move or increasing your risk of foreclosure
• Need to refinance to remove mortgage insurance premiums
• Limited to buying a home with a mortgage within loan limits and for use as a primary residence

Alternatives to FHA ARM loans

An FHA mortgage is not your only option. Some alternatives to FHA ARMs that can help you buy a home include:

• HomeReady mortgage: Fannie Mae‘s HomeReady program requires a minimum 620 credit score. You do not have to be a first-time homebuyer, but you will need an income lower than 80 percent of the area median income. You’ll also need to take a homeowner’s education course.
• Standard 97 Home Loan: Also provided by Fannie Mae, this mortgage requires 3 percent down, and at least one borrower must be a first-time homebuyer.
• HomeOne Loan: Freddie Mac offers the HomeOne Loan for first-time homebuyers, and it has no income or geographic limits. You can put down a minimum of 3 percent on a home with this loan.
• Home Possible Mortgage: Also offered by Freddie Mac, the Home Possible mortgage is a loan option for very low- to low-income homebuyers. You must meet qualifying income limits: no more than 80 percent of the area median income.

These mortgages are for primary residences only, so you will need to look at other options should you require a mortgage for a second home or investment property.

Refinancing an FHA ARM

Many borrowers refinance before the first ARM rate reset. You might want to refinance out of an ARM loan into a fixed-rate one if rates have dropped since you first obtained the loan and you want the stability of a non-fluctuating rate. You can also refinance to another ARM.

If you qualify, you might want to refinance from an FHA mortgage to a conventional loan, too. This allows you to eliminate (or work toward eliminating) mortgage insurance premiums, as conventional loans only require insurance if you have less than 20 percent equity in your home. In contrast, most FHA loans require you to pay insurance for the entire loan term, regardless of how much you’ve paid down the mortgage.

Keep in mind, refinancing is typically only worthwhile if you can get a lower rate and pay the closing costs. If you won’t be in the home long enough to recoup those costs and realize the savings, it might not make financial sense to refinance.

Bottom line on FHA adjustable-rate mortgages

The considerations for getting a FHA adjustable-rate mortgage vs. a fixed-rate one are similar to the considerations for their conventional loan cousins. ARMs work best for homeowners who are pretty sure they’ll be leaving their home within a certain number of years (coinciding with the end of the ARM’s fixed-rate period, or before) or who anticipate a big increase in income (because the ARM’s new, reset rate often means higher repayments).

Other than that, your main decision is whether it’s worth jumping through the extra application/appraisal hoops and paying the MIP that comes with FHA loans. If the better terms still seem worth it, then go for it.