FHA ARM Loan Your Comprehensive Guide

Have mortgage rates risen so quickly that you can no longer afford a home?

You’re not alone.

According to Mortgage News Daily, the average 30-year fixed mortgage shot from 3.08% in November 2021 to 6.95% less than a year later.

The good news is that you don’t have to get a 30-year fixed loan.

FHA, the go-to choice for many first-time buyers, offers an adjustable-rate mortgage (ARM) program that gives you a lower rate upfront.

Want to see how low your payment can be? Consider an FHA ARM loan.

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What is an FHA ARM loan?

An FHA ARM loan is a mortgage that comes with an initial fixed rate that changes later in the life of the loan.

For instance, an FHA 5-year ARM is fixed for five years, then adjusts yearly during years 6-30.

Why would someone choose an adjustable rate over fixed? While it comes with more risk, there’s also a reward.

FHA ARM rates are typically lower than a comparable fixed-rate loan, saving you money each month during the initial fixed period and potentially even longer.

*Rates and rate difference are examples only and may not be currently available. Your rate difference will vary. Payment does not include taxes, insurance, HOA dues, or FHA MIP.

In this example, the homebuyer saves $164 per month and nearly $10,000 during the five years. After that, the homeowner can simply let the rate start to adjust, refinance the mortgage, or sell the home. 

This program could be a good solution for those struggling to qualify to buy a house in the current rate environment.

Who are FHA ARMs good for?

FHA ARMs are not for everyone, but they are a great fit for some homebuyers. You might consider an ARM if:

• You will sell the home within 5-7 years.
• You plan to refinance.
• Your income will increase in the future and will be able to afford a higher payment.
• You believe rates will drop in the next few years, at which time you will refinance into a low fixed-rate loan or let the ARM adjust downward.
• You will receive a financial gift, bonus, or inheritance in the next few years and can refinance into a lower loan amount or pay off the mortgage.

Overall, an ARM is perfect for someone who will not carry the loan for long or is comfortable with exploring options when the adjustment period gets closer.

4 components of an FHA ARM loan protect the borrower

Some homebuyers assume that the day their adjustable period starts, their payment will double and they will lose their home. Luckily, that’s a false assumption propagated by the media.

In real life, all FHA ARMs and most other ARM loans come with certain borrower protections. Here are four components of an ARM, each protecting the homeowner in its own way.

Keep in mind that the last three components in this list only apply if you enter the adjustable-rate period.

Component 1: Initial interest rate period

This is how long you will have a fixed rate. A 5-year FHA ARM is fixed for five years; a 3-year ARM is fixed for three years. Your rate and payment are locked in during this time and there is zero chance of your rate rising. FHA allows 1, 3, 5, 7, and 10-year fixed periods, although not every lender offers every ARM type.

Tip: Interest rate at the first adjustment period will equal Component 2 (Index) plus Component 3 (Margin).

Component 2: Index

The index is a measure of the current interest rate market. Most FHA ARMs are based on the Constant Maturity Treasury, or CMT, index. The CMT index is 4.07% as of Sept. 30, 2022. Borrower protection: The lender cannot manipulate the index to make you pay a higher rate. It is based on U.S. Treasury bond yields which are determined by the overall market, not the lender.

Component 3: Margin

The margin is set by the lender when you open your loan. It is meant to provide interest income and profit for the lender. Your index plus margin will be your rate if and when the FHA ARM starts to adjust. That’s why it’s good to confirm your margin and shop for the lowest one. Borrower protection: The lender can’t increase its margin at any time after loan closing.

Example: FHA ARM loan rate when it starts to adjust:

4.00% index + 2.5% margin = 6.5% rate.

Component 4: Interest rate caps

FHA ARMs come with limits on how high and fast the rate can rise after the fixed period. These limits are called “caps.” Common FHA caps are 2/2/6. This means:

• 2% max increase upon the first adjustment
• 2% max increase each year thereafter
• 6% max increase during the life of the loan.

For instance, if you received an FHA 5-year ARM at 5.5%, after five years, it could not rise above 7.5% at first adjustment, 9.5% the next year, and never more than 11.5%.

FHA ARMs typically come with either 2/2/6 or 1/1/5 caps, depending on the lender and initial fixed period. Borrower protection: FHA ARM caps limit rate and payment increases at each adjustment and throughout the life of the loan.

What is a 5/1 FHA ARM loan?

An FHA 5/1 ARM is an FHA loan that is fixed for five years then starts adjusting. The “/1” means that the loan can adjust only once per year starting in year six.

There are also 1/1, 3/1, 7/1, and 10/1 FHA ARMs, although not every lender offers every type. The most available type is the 5/1.

Can you use FHA ARM loan rates to get a lower DTI and qualify?

Yes, you can use your start rate on an FHA arm to help you qualify.

The biggest advantage to FHA ARMs is that your rate is reduced for the first few years of the loan.

But another advantage is that the lender can use the initial rate to qualify your loan (unless it’s a 1-year ARM in which the lender must qualify at the initial rate plus 1%).

Let’s see how an FHA ARM can help you get approved.

*Rates and rate difference are examples only and may not be currently available. Your rate difference will vary.

In this example, you would have a 52% DTI with a 30-year fixed-rate loan which is a little high and might receive a denial. A 48% DTI using a 3/1 FHA ARM could push you into “approved” territory.

FHA ARM alternatives

Standard adjustable-rate mortgages

• Conventional 3-year ARM
• Conventional 5-year ARM
• Conventional 7-year ARM
• Conventional 10-year ARM
• VA adjustable-rate mortgage

Interest-only adjustable-rate mortgages

• 3-year interest-only ARM
• 5-year interest-only ARM
• 7-year interest-only ARM
• 10-year interest-only ARM

FHA ARM lenders

Finding a lender who issues low-rate FHA ARMs could be a challenge. The mortgage market went a bit haywire in early 2022 and all ARMs became harder to find.

But some lenders still offer them. Call around to big national banks and mortgage brokers. Big banks can keep loans “on the books” instead of selling them on the secondary market.  Mortgage brokers can search dozens of banks and lenders to find the right FHA ARM program for your situation.

Become a homeowner with your FHA ARM loan

FHA ARM loans are not the dangerous products of the mid-2000s.

Rather, these loans come with built-in protections that can also help you qualify for a home.