What Is An FHA Adjustable-Rate Mortgage And Is It Right For You?
FHA loans offer several advantages, including a low required down payment and more flexible credit requirements. They also come in a variety of traditional fixed-rate terms. One option you might not be aware of is an FHA adjustable-rate mortgage (ARM). We’ll go over what it is, how to qualify, the pros and cons, and whether an FHA ARM is right for you.
What Is An FHA Adjustable-Rate Mortgage (ARM)?
An FHA adjustable-rate mortgage is an ARM backed by the Federal Housing Administration. Before we go into what’s offered, let’s briefly discuss how an adjustable-rate mortgage differs from a fixed-rate mortgage.
With a fixed-rate mortgage, your interest rate doesn’t change for as long as you have the loan. This means your principal and interest payment remains constant each month. The only way your monthly payment changes is with fluctuations in your taxes and insurance.
With an adjustable-rate mortgage, your rate is fixed for a given number of years at the beginning of your loan term. Once this fixed period expires, your rate can adjust up or down when called for in your contract. The amount of the increase or decrease in your interest rate is subject to caps and floors as well as a margin. The margin is added to an index to get your new interest rate.
In addition to a traditional fixed FHA loan, you can get an FHA ARM in 1-year, 3-year, 5-year, 7-year and 10-year varieties. These timeframes refer to how long the interest rate stays fixed at the beginning of the loan. In many cases, the term of the ARM is 30 years, although this can vary. Confirm with your lender. At the end of the fixed period, rates adjust once per year.
Rocket Mortgage® offers clients an FHA 5-year ARM.
How To Qualify for An FHA Adjustable-Rate Mortgage
In order to qualify for an FHA adjustable-rate mortgage, or any FHA loan, you have to meet the following requirements:
- Credit score: Your median FICO® Score needs to be at least 580 to qualify at Rocket Mortgage. It’s important to note that there is more flexibility around debt-to-income ratio (DTI) if you have a score of 620 or better.
- Down payment: All FHA loans require a down payment of at least 3.5%. With a down payment of 10% or more, monthly mortgage insurance premiums end after 11 years. Otherwise, they persist for the life of the loan.
- DTI: Speaking of DTI, there are a couple of different calculations to think about. If you’re qualifying with a median credit score below 620, your housing expense ratio – the amount of your mortgage payment compared to your pretax monthly income – can’t be higher than 38%. Your overall DTI can’t be higher than 45% when your other monthly debts like student loans and minimum credit card payments are added back in. If you’re above a 620 qualifying credit score, maximum DTI is often decided on a case-by-case basis, but can’t be higher than 57% when considering all monthly debt payments.
- Residency: The FHA requires that the home be used as your primary residence. This means you have to live in the home for more than 6 months out of the year.
Beyond personal financial qualifications, you should also be aware of FHA appraisals. An appraisal serves two purposes. There is the one everybody thinks about, which is to give an opinion of the value of the property, which prevents the buyer from unknowingly overpaying and the lender from loaning more than the property is worth.
The other purpose of all appraisals is to make sure the property is what is called “move-in ready.” Move-in readiness means there are no health and safety concerns that would be detrimental to someone’s enjoyment or use of their new property. For example, there can’t be loose floorboards or a hole in the roof.
To these requirements, the FHA adds a few special conditions of its own. The most well-known is the need to check for and remediate any chipping or peeling paint in houses built prior to January 1, 1978, due to the possibility of the presence of lead.
The Pros And Cons Of FHA ARM Loans
As with any other type of mortgage, there are pros and cons to FHA ARMs.
Pros Of FHA ARM Loans
- Lower initial rate than comparable fixed-rate loans: If you go with an ARM, you could have a lower required monthly payment for several years at the beginning of the loan. This could be advantageous if you plan to take the savings and use them to significantly pay down your balance before the rate adjusts, lowering your payment when it finally does. On the other hand, if you’re only in the house a short time, you may move out prior to the adjustment
- Adjustment caps: There are limits to how much your rate can go up at the initial adjustment, on each subsequent adjustment and over the life of the loan. Because of this, your rate can’t go up indefinitely.
- Low down payment: If you have a score of 580 or better, you only need a 3.5% down payment, which is lower than some other options.
- Flexible credit requirements: In theory, you can get an FHA loan with a credit score as low as 500 if you have a 10% down payment. Most lenders, including Rocket Mortgage, require a median qualifying score of at least 580, but this is still better than the 620 requirement for conventional loans.
Cons Of FHA ARM loans
- Potential for payment shock: When you qualify for an ARM, it’s assumed that you’ll be paying the highest possible interest rate you could under your loan terms, assuming the market doesn’t move in your favor. So your lender knows at the time you qualify that you can afford the payment. However, a lot can change in the intervening years. Even if you can afford it, a dramatically increased payment can put a strain on your finances and you should be prepared.
- You could pay more interest: Because interest rates can go up, you could end up paying more interest than you would if you had a fixed-rate loan.
- Interest rate floors: You might think that if interest rates have dropped 3% between the time your initial rate was set and the adjustment that you’ll see a 3% decline in your interest rate. That won’t always be the case. The same mechanisms that limit how much your rate can adjust upward also limit how much your rate can fall. Additionally, the rate will never drop below your lender’s margin.
- Mortgage insurance premiums (MIP): Non-streamline FHA loans require an upfront mortgage insurance premium of 1.75% that can either be paid at closing or built into the loan amount. There is also monthly MIP. If the down payment is less than 10%, it lasts for the life of the loan. If your down payment or equity amount is 10% or higher, it’s canceled after 11 years.
- No vacation homes or rental properties: The property must be a primary residence. This means no vacation homes or investment properties. It’s worth noting that you can buy a primary residence with up to four units. So, you can live in one unit and rent out the other three for passive income.
Is An FHA ARM Loan Right For You?
When considering any loan option, it’s important to first make sure you qualify. So for an FHA loan, you need a minimum down payment of at least 3.5% and a qualifying credit score of 580 at Rocket Mortgage. In general, the better your qualifications, the more loan options you qualify for.
When specifically considering an ARM, there are a couple of things you should think about:
- How long will you be in the house? If you plan on being in the house for only a few years, you may move before the rate ever adjusts. If you stick to that plan, you could take advantage of a lower rate than on comparable fixed loans without having to worry about the rate potentially rising.
- Does the rate environment make sense? This is something you’ll have to work on with your lender, but there are times when it’s better to get a fixed rate depending on conditions in the bond market. Your Home Loan Expert will be able to guide you. Sometimes difference you’ll get in the rate initially doesn’t make it worth the risk of your rate going up in the future.
It’s important to speak with our Home Loan Experts about your situation.
The Bottom Line: Weigh The Pros And Cons of FHA Adjustable-Rate Mortgages
An FHA adjustable-rate mortgage has a lower starting rate than a comparable fixed-rate mortgage, with the trade-off that the rate can go up or down at the end of a fixed period.
If you’re interested in paying down your loan for a lower balance when it adjusts or you’re only going to be in the home for a short time, they can make a ton of sense. On the other hand, rates can also go up, meaning you can have payment shock and pay more in interest.
What’s right for you really depends on your situation. Given that, work with our team to figure out what makes the most sense for your finances and homeownership journey. To look into your options, you can apply online or give us a call at (833) 230-4553.