FHA ARM: What It Is And How It Works

When mortgage interest rates rise, homebuyers often turn to adjustable-rate mortgages, better known as ARMs. The reason? These loans come with an initial interest rate that is typically lower than what you'd get with a standard 30-year or 15-year fixed-rate mortgage. This gives buyers the chance to save a significant amount of money each month in the earlier years of paying off an ARM.

But what if your credit score isn't perfect or you don't have the funds for a larger down payment? Can you take out an FHA loan and still receive the low-interest-rate benefit of an ARM?

You can. The Federal Housing Administration offers a variety of ARMs. And depending on your financial situation, these loans might make sense for you.

What Is An ARM?

ARMs become popular when mortgage interest rates are increasing. That’s because these loans come with a lower interest rate during a set fixed period. This lower rate might stay in place with some ARMs for five years. For others, the initial interest rate will remain low for seven years.

After this fixed period ends, the interest rate enters its adjustment period, rising or falling depending on the economic index to which the ARM is tied. With most ARMs, the interest rate will adjust once a year after the fixed period ends, doing so until borrowers pay them off, sell their home or refinance to a different type of loan.

That is the risk with an ARM: The odds are that your monthly mortgage payment will rise after the fixed period ends and your loan’s interest rate jumps. Make sure you can afford this higher payment before taking out an ARM. Many homeowners will refinance to a fixed-rate mortgage before their ARM enters its adjustment period. Others plan on moving before their loan slips into this phase.

FHA Adjustable-Rate Mortgages: A Closer Look

If you do want an ARM, you can get one that is insured by the Federal Housing Administration. This type of loan, known as an FHA ARM, combines the benefits of a low initial interest rate with the positives of an FHA loan.

If your FICO^® credit score is 580 or higher, you’ll only need a down payment of 3.5% of your home’s purchase price. FHA loans are generally available to borrowers with lower credit scores, too.

Types Of FHA ARMs

The FHA offers five types of ARMs.

• The FHA's 1-year ARM has a fixed interest rate for 1 year. The rate can then increase by one percentage point each year after this fixed period ends. The 3-year ARM has a fixed rate for the first 3 years and can then increase by a maximum of one percentage point each year after. With both ARM types, the interest rate can rise by a maximum of five percentage points during the life of the mortgage.
• The FHA's 5-year ARMs have a 5-year fixed period. There interest rates can increase by up to one percentage point annually and five percentage points over the life of the loan or up to 2 percentage points each year and a total of six percentage points over the life of the mortgage.
• The interest rates with the FHA's 7-year and 10-year ARMs may only increase by a maximum of two percentage points each year after the fixed period – 7 or 10 years – ends. The interest rates on these loans can only increase by a maximum of six percentage points over their lifespans.

FHA ARMs Vs. FHA Fixed-Rate Mortgages

The FHA also offers fixed-rate mortgages. As with FHA ARMs, if your FICO® credit score is 580 or higher, you’ll only need a down payment of 3.5% of your home’s purchase price with a fixed-rate mortgage insured by the FHA.

With a fixed-rate loan, though, your interest rate never changes. If your 30-year fixed-rate mortgage has an interest rate of 5.6% in its first year, it’ll have the same rate 29 years later. The benefit of this is certainty: You don’t have to worry about your interest rate ever increasing.

On the downside, you won’t benefit from those lower initial interest rates that come with ARMs.

FHA ARM Requirements

As with all mortgage types, you’ll need to meet certain requirements to qualify for an FHA ARM.

Credit Score

You’ll need a FICO^® credit score of at least 580 to qualify for an FHA ARM with a down payment of just 3.5% of your home’s purchase price. If your credit score is at least 500, the FHA states that you can qualify for an FHA ARM by putting up a down payment of at least 10% of your home’s final purchase price.

Private lenders, though, originate FHA loans. They might have their own credit score requirements and might not approve you if your FICO^® credit score is too low, despite the FHA’s minimum requirements.

Debt-To-Income (DTI) Ratio

Your debt-to-income ratio, or DTI ratio, measures the relationship between your income and debts. In general, mortgage lenders prefer that your monthly debts, including your new monthly mortgage payment, equal no more than 43% of your gross monthly income. Shoot for a DTI ratio of 43% or lower, then, to boost your odds of qualifying for an FHA ARM.

Down Payment

The FHA requires that you come up with a down payment of at least 3.5% of your home’s final purchase price if you have a FICO^® credit score of at least 580 and 10% if your credit score is at least 500. The higher your down payment, though, the lower your interest rate tends to be.

Pros And Cons Of FHA ARMs

As with all mortgage types, FHA ARMs come with both positives and negatives.

Pros

• FHA ARMs come with low initial interest rates. This will result in a lower monthly payment during the earlier years of your loan.
• You won’t need a large down payment with an FHA ARM. Depending on your credit score, you’ll need a down payment of just 3.5% of your home’s final purchase price.
• You might qualify for an FHA ARM with a lower credit score. Lenders vary, but the Department of Housing and Urban Development says that it’s possible for borrowers to quality for FHA loans with FICO® credit scores as low as 500.

Cons

• Once your loan’s fixed period ends, it will enter its adjustment period. During this time, your interest rate will adjust once a year, usually rising higher. Your monthly mortgage payments, then, will also be higher.
• With all FHA loans, borrowers pay a mortgage insurance premium or MIP. You'll first pay an upfront MIP of 1.75% of the total value of your loan. If you borrow $150,000, you'll pay $3,500 for your upfront MIP.
• You'll also have to pay an annual MIP each year. The annual MIP ranges from 0.15% – 0.75% of your loan amount, depending on the length and size of your loan. If you come up with a down payment of more than 10% of your home's purchase price, you'll pay this annual MIP for 11 years. If your down payment is less than 10%, it will remain for the life of your loan.

FHA ARM Rates

The interest rates for ARMs typically are lower than those you'd get with a standard fixed-rate mortgage. Freddie Mac reported that the average interest rate on a 30-year fixed-rate mortgage stood at 5.51% on July 14 of 2022. On that same date, the average rate for a 5/1 ARM was 4.35%.

Remember, though, that mortgage interest rates rise or fall frequently. Usually, though, the initial interest rate with an FHA ARM will be lower than the rates on 15-year or 30-year fixed-rate loans.

Can You Refinance An FHA ARM?

You can refinance from an FHA ARM to a standard fixed-rate mortgage. Many homeowners do this before their ARMs reach the adjustable phase. This way, they get the benefits of lower monthly payments without the uncertainty of fluctuating interest rates.

You’ll need 20% equity in your home to avoid paying private mortgage insurance on a conventional mortgage. If you are making your mortgage payments each month and the value of your home has risen, this usually isn’t a problem.

Most lenders will send an appraiser to determine the value of your home before they approve your request for a refinance.

How To Apply For An FHA ARM

Most lenders originate FHA loans. To apply for an FHA ARM, then, you’ll need to contact a lender to start the process. This lender will check your FICO^® credit score and ask for documents that prove your income.

Typically, you’ll need to provide lenders copies of your last two paycheck stubs, last 2 months of bank account statements, 2 most recent years of income-tax returns and your W-2 forms from the last 2 years.

You might also have to provide proof of employment. Typically, this means sending your lender a statement from a supervisor, on company letterhead, stating your position, yearly salary and years on the job.

Once your lender has this information, it will send your application through the underwriting process. This is when underwriters determine whether your credit and finances are strong enough for a mortgage loan.

The Bottom Line

An FHA ARM can provide you with a lower monthly mortgage payment for several months. Just make sure you can handle the larger payments that are almost certain once your loan enters its adjustment period and your interest rate rises or falls each year. If you’re considering an FHA ARM, talk with a Home Loan Expert.