Thinking about buying a home this spring? You'll want to check out the latest update to the income needed to buy a median-priced home in the top 50 metro areas.

Thinking about buying a home this spring? You'll want to check out the latest update to the income needed to buy a median-priced home in the top 50 metro areas.

All About FHA Adjustable Rate Mortgages

Keith Gumbinger

options-for-FHA-loan When most people talk about the FHA loan program, they most likely think of 30-year fixed rate mortgages with low down payments available even to folks with less-than-stellar credit. That's all of course correct, but there's a side of the FHA forward-mortgage program that's not often discussed or considered, but should be: The FHA also backs adjustable-rate mortgages. Given today's more challenging interest rate environment for fixed-rate loans, an FHA ARM might be a good choice for a homebuyer or even for a homeowner looking to refinance.

Tha FHA backs ARMs?

The FHA has long backed adjustable rate mortgages, but it's worth remembering that the FHA program is simply an insurance pool that helps indemnify a lender against risk. An FHA-approved lender can make a loan that meets FHA's underwriting requirements, and the borrower pays for insurance against loss via both upfront and recurring Mortgage Insurance Premiums (MIP). Even when they have FHA approval and can do so, lenders are still free to choose which FHA-backed products they will offer and most focus on fixed-rate offerings.

Why don't many lenders offer FHA ARMs?

While fixed-rate government-backed mortgages (FHA, VA and USDA offerings) are originated in sufficient volume as to see them be incorporated into mortgage-backed securities and guaranteed by Ginnie Mae, relatively few ARMs are originated, and lenders typically keep the ARMs they make in their investment portfolio. This arrangement is most common where a lender is also a depository institution, such as a bank, but less common among mortgage banking concerns, who generally don't have investment portfolios of loans. In today's mortgage market, most FHA-backed loans are made by mortgage bankers, but without an investment portfolio in which to place them, many FHA lenders won't offer FHA ARMs unless they have a willing buyer for them when they are originated, called a "correspondent lending" arrangement.

How are FHA ARMs different than conforming ARMs?

Rate Adjustment Intervals
FHA ARMs differ from conventional or conforming ARMs in several key ways. To start with, FHA ARMs still feature one-year rate adjustment periods; this includes traditional 1-year ARMs (rate adjusts every 12 months) and hybrid ARMs, where a fixed-rate period of 3, 5, 7 or 10 years is in place before annual rate adjustments begin.

The conventional mortgage market used to widely offer 1-year ARMs, or hybrid ARMs with one-year adjustment periods, but not so much any more. While lenders do like to keep ARMs in their portfolios, they still prefer to have the option to sell eligible ARMs to Fannie Mae or Freddie Mac as their portfolio needs change. In recent years, Fannie and Freddie moved away from one-year adjustment periods in favor of loans with six-month rate change intervals, and also now only buy ARMs that are based upon the Secured Overnight Financing Rate (SOFR), and even then, only those that utilize a 30-day average of this index.

This means that for lenders who are actively originating ARMs, some may only offer ARMs that can easily be sold to Fannie or Freddie if desired, so in turn ARMs with one-year adjustment periods have become more scarce.

Index Differences
With the discontinuation of LIBOR as an ARM index, FHA ARMs now also allow for the use of SOFR to govern future interest rate changes. However, unlike Fannie Mae and Freddie Mac, the use of the one-year Treasury Constant Maturity to govern rate changes is still allowed. This index is perhaps the most traditional and venerable of all the ARM indexes and unlike the relatively new SOFR has a long history, so borrowers can see how it has performed over many economic cycles if they wish.

Now this is not to say that one index is better than the other; both will reflect changes in the cost of capital over time. Treasury values tend to move in a more spiky fashion, influenced by a combination of market-based conditions and monetary policy, while the 30-day SOFR seems to be most greatly influenced by monetary policy changes (especially changes in the federal funds rate) albeit at a lag due to the way it is produced.

What matters more than the value of the index -- over which the lender has no control -- is the margin added on top of that index, over which the lender has at least some control. Shopping for a lender who offers a lower margin (if one can be found) will always save you money compared to a loan with a higher margin.

In the HUD Handbook (4155.1 6.B.2.d - "ARM Loan Features") HUD notes that "The lender and borrower negotiate the initial interest rate and margin. The margin must be constant for the entire term of the mortgage." If you're discussing an FHA ARM with a lender, you might see if you can negotiate a lower margin -- perhaps by accepting a slightly higher initial interest rate, if it doesn't affect your ability to qualify for the loan.

Of course, you'll need to be in the loan through at least an adjustment or two for a lower margin to have much effect, so this might only be applicable for a 1/1 or 3/1 ARM. Consider that if you should select a 7/1 ARM and then refinance at some point during the first seven years, the margin never comes into play at all, and you'll likely have paid more for the fixed-rate portion of the loan that you would have otherwise.

Cap Structure Differences
FHA ARMs also have a few other significant differences compared to conventional offerings: The way their interest-rate limiters ("caps") are structured. On balance, FHA ARMs offer more favorable cap structures than do conventional ARMs, helping to limit any payment increases during times of rising rates.

One-year (1/1) and 3/1 FHA ARMs have initial cap (aka "first-adjustment cap") of one percentage point, followed by a one-percentage point limit on every rate adjustment (called the "periodic cap") thereafter, and the maximum interest rate ("lifetime cap") is limited to five percentage points above the loan's starting rate. This is called a "one-one-five" (1/1/5) cap structure. Conventional ARMs with the same adjustment periods often feature 2/2/5 or 2/2/6 caps, so the FHA ARM offer a borrower greater protection from rising rates... but can also limit any beneficial improvement in rate and payment if market-based interest rates decline meaningfully.

It's not just shorter-term FHA ARMs that have lower interest rate change limits. Longer-term FHA hybrid ARMs do too, such as the 1/1/5 (Treasury-based) or 2/2/6 (SOFR-based) cap structures found on 5/1 FHA ARMs. In both cases, that initial cap is much lower than what is commonly found on many conventional ARMs, which most often have 5/2/5, 5/2/6 or even 6/2/6 cap arrangements.

That's also the case with longer-term ARM caps; for 7/1 and 10/1 ARMs that the FHA backs, they allow for 2/2/6 caps where the open market typically sees these products with 6/2/6 interest-rate limiters.

Suffice it to say that an FHA-backed ARM may provide a borrower with greater interest-rate and payment increase protection than a conventional or conforming ARM would. At the same time, the borrower might not be able to take full advantage of a significant drop in interest rates, at least in the near term.

Qualifying for an FHA ARM is different, too
Qualifying for a conventional ARM -- one that follows the guidelines from Fannie and Freddie, anyway -- isn't as simple as it seems. For ARMs with an initial fixed interest rate period of three years or less, the borrower will be qualified at the highest possible rate that could apply during the first five years of the loan -- and the qualifying interest rate determines how much mortgage the borrower will be allowed to obtain.

As a quick example, a 3/6m ARM has a starting contract rate of 3% for the first three years, and the rate can be increased by 1% at each interval thereafter. Over the first five years, this means four interest rate adjustments, and each could lift the rate by 1 percentage point. This means the qualifying rate isn't 3%, but rather 7%.

How does this affect qualifying for a conventional ARM? It limits the amount the borrower can obtain. An $80,000 income might allow a borrower to qualify for as much as $311,000 at 3%, but only about $220K at qualifying rate of 7%. This higher qualifying interest rate limits the amount a borrower's income can carry... but at least the $220K they do qualify to borrow will carry a contract interest rate of only 3% for the first three years of the loan. The loan's monthly payments are based on the contract interest rate, not the qualifying interest rate.

For ARMs with fixed rates of 5 years, the lender must use the higher of the maximum rate that could apply during the first five years after the first payment date (this would be the initial note rate plus first rate change cap), or the fully-indexed rate (value of the loan's index plus the loan's margin).

Longer-dated ARMs (7- of 10-year) see the borrower qualify at the contracted interest rate. Simply stated, a borrower considering a conforming is no longer qualified for the mortgage amount they will be allowed to borrow at an introductory or "teaser" interest rate.

FHA ARMs are different, though. For ARMs that have a one-year adjustment period -- that is, a traditional 1/1 ARM -- the borrower is qualified at the initial contract rate plus 1 percentage point if they are making a down payment of less than 5%. As such, if a lender is offering a 3% FHA-backed 1/1 ARM, the borrower would qualify as though the interest rate was 4%. For the same ARM with a down payment of more than 5%, they will be qualified at the loan's initial interest rate.

For ARMs with longer fixed-rate periods -- 3, 5, 7 or 10 years -- the lender will use the loan's initial note rate to qualify the borrower for the mortgage amount.

With an FHA ARM -- and unlike a conforming ARM -- it's possible to be qualified for the amount you'll be borrowing with the loan's initial interest rate. If a FHA 5/1 ARM is offered at a 4% interest rate, this is the rate at which you'll be qualified to borrow.

No interest-rate "buydowns"
Another difference from conforming ARMs is that FHA ARMs don't allow temporary interest rate "buydowns". With a conventional 3/1 ARM, a lender may be able to offer a 2-1 buydown; for example, the loan's contract rate might be 4%, but you would make payments in the first year of the loan as though it had a 2% rate, and after the first year, this would increase to a 3% rate and then back to a 4% rate for the third year. After that, future rate adjustments would be governed by changes in the ARM's index.

Conventional 5-, 7- and 10/6m ARMs can offer 2-1 or even 3-2-1 buydowns in the earliest years of the loan. Such arrangements are unusual, but they are allowed if a lender is interested in offering such an arrangement. That's not the case with FHA ARMs.

"Teaser Rate" Control
Conventional conforming ARM also have limits or how low the initial contract rate can be, and the lowest rate a lender can offer on one of these ARMs is the fully indexed rate minus three percentage points. For example, if the index plus margin adds up to 7%, the lowest rate the lender can offer and still have the loan meet conforming requirements would be 4%. The FHA has no such published formula, saying only that "The Mortgagee [lender] must underwrite the Mortgage based on payments calculated using the initial interest rate."

Are FHA ARMs better than other ARMs?

It's not so much a matter of whether FHA ARMs are better than any other ARMs you may find. However, they can have advantages, such as:

  • Lower qualifying interest rates
  • Longer adjustment frequencies
  • Potentially less fluctuation in interest rate when the product's interest rate changes
  • A borrower may be able to make a smaller down payment on a FHA-insured ARM than they would with a conventional or conforming ARM
  • A 1/1 ARM may allow a borrower a greater chance at a lower interest rate sooner if interest rates are high when buy a home or refinance.

There can be drawacks to FHA ARMs, too:

  • A cap of 1% per year may limit the borrower's chance at an even lower interest rate
  • FHA ARMs will carry mortgage insurance premiums that may not be cancelable
  • An ARM using the Treasury index may be more volatile than a SOFR-based ARM
  • It may be difficult to find a lender offering FHA-backed ARMs

Should I take an FHA ARM?

Whether the advantages of an FHA ARM outweigh any drawbacks will depend on how well the product fits your needs, and this will depend on a unique-to-you combination of factors. This starts with answering the question as to whether any ARM at all is right for your situation; if it is, you then might see how well both a conventional, conforming or FHA-backed ARM will fit your needs.

A good place to start is by understanding ARMs in general and how they work and the kinds of borrowers and situations for which they are most applicable. HSH's comprehensive Guide to Adjustable Rate Mortgages can help you to see how an ARM might work for you and your situation. If an FHA ARM is right for you, you'll want shop a range of mortgage lenders for the best available deal on yours.

Related: FHA MIP Calculator and Low Downpayment Mortgage Comparator

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