FHA loan benefits include low down payments and easier credit qualifying; FHA adjustable rate mortgages offer lower initial FHA interest rates along with additional benefits. Here's how FHA ARM loans work and when they may work best for home buyers.
FHA ARM Loans: How They Work
According to the Department of Housing and Urban Development (HUD), FHA adjustable rate mortgages are structured using four components:
- Index: This is the financial index used for determining adjustments to FHA interest rates on an ARM. The financial index used is specified in FHA mortgage documents. FHA allows mortgage lenders to use either the Constant Maturity Treasury Index (CMT) or the one-year London Interbank Offered Rate Index (LIBOR).
- Initial interest rate period: This is a specified period that provides a lower fixed interest rate. When the initial fixed rate period expires, the loan becomes and FHA adjustable rate mortgage with an annual interest rate adjustment. FHA offers a standard one-year ARM and four hybrid ARM loans with initial fixed rate periods of three, five, seven or ten years.
- Margin: The margin is an additional amount added to the index rate by a mortgage lender. For example, if the index rate is 1.750 percent and the lender adds a margin of 1.25 percent, the mortgage rate would be 3.00 percent.
- Interest rate caps: Caps establish maximum or minimum amounts that FHA mortgage rates can rise or fall. There are two types of caps for ARM loans. The first is an annual cap, which limits how much an interest rate can adjust in a one-year period. Lifetime caps establish how much an interest rate can rise or fall during the life of an FHA ARM loan. Lifetime caps can override annual interest rate adjustments if the annual adjustment would result in a mortgage rate exceeding the maximum increase allowed by a lifetime cap. Interest rate caps protect homeowners from excessive rate increases.
Rate Caps Keep FHA Interest Rates Low
FHA ARM loans have low caps that help maintain affordable mortgage payments for ARM borrowers. The annual cap for one-year ARMs and three-year hybrid ARMs is one percent (half the typical cap for conventional ARMs!) and the lifetime cap is five percent (typical conventional loan caps are one percent higher at six percent). If the initial mortgage rate is three percent, the FHA mortgage rate could not increase beyond eight percent over the life of the loan. Annual caps for FHA 5/1, 7/1 and 10/1 hybrid loans cannot exceed two percent and the lifetime cap is six percent. A great advantage of three FHA ARM loan is that you can qualify with as little as 3.5 percent down and will enjoy the benefits of an initial mortgage rate that's lower than FHA interest rates for fixed rate mortgages. You can also benefit from an FHA adjustable rate loan under certain circumstances.
Those purchasing a home with an FHA ARM can save with the lower initial fixed rate on an FHA hybrid ARM and later sell or refinance with no prepayment penalty. FHA does not allow mortgage lenders to charge prepayment penalties on FHA loans. Finally, if you later decide to refinance out of an FHA ARM loan, you may qualify to refinance to a fixed rate mortgage with FHA's streamline refinance program.