How an FHA Adjustable-Rate Mortgage (ARM) Works, and When to Use It

FHA-insured home loans are available with both fixed and adjustable interest rates. There are certain pros and cons associated with each type. The article explains how an FHA adjustable-rate mortgage (ARM) loan works, and when it might make sense to use one.

Most home buyers who use ARM loans do it to save money during the first few years. This is the primary appeal of adjustable mortgage products — they typically start off with a lower interest rate, compared to fixed mortgages.

But later, many of these same homeowners run into trouble when their FHA ARM loans adjust to higher interest rates. In some cases, these adjustments or “resets” can greatly increase the size of the borrower’s monthly payment. This catches some people off guard.

Knowledge is key. So in this guide, we will examine the adjustable-rate mortgage in detail. After reading this guide, you’ll have a better understanding of how the FHA ARM loan works, and when it might make sense to use one.

How an FHA ARM Loan Works

An adjustable-rate mortgage differs from a fixed-rate loan in the way it adjusts to a new interest rate at some future point in time. Fixed home loans carry the same interest rate through the entire term or “life” of the loan, even if it’s 30 years. So the rate you pay in the first year would be the same as years 5, 10, 15 … all the way through the end of the repayment term.

An FHA adjustable-rate loan, on the other hand, has an interest rate that will change periodically — typically every year, after the initial phase expires. This can cause the monthly payments to increase or decrease, depending on the prevailing rate at the time of adjustment (and other factors). More often than not, the monthly payment will increase from one annual adjustment to the next, because rates tend to rise over time.

As mentioned earlier, ARM loans typically start off with a lower interest rate than their fixed counterparts. But keep the following points in mind:

  • Unlike a fixed-rate mortgage, the payments on an FHA ARM loan can change (and possibly rise) over time.
  • You cannot predict what interest rates will be three or five years from now, when your ARM loan adjusts.

Key Ingredients: Initial Phase, Adjustment, and Rate Caps

When shopping for a mortgage, it’s important to compare the rates and terms offered by different lenders. It’s like anything else in life — only by shopping around can you find the best deal.

However, comparing one FHA ARM loan to another can be a little confusing. They are more complicated than “regular” fixed mortgage products, so you have to do some additional homework. Specifically, you need to research and understand the concepts of index, margin, caps, payment options, and other concepts that don’t apply to the much simpler fixed-rate loans.

To get an even better understanding of how an FHA ARM loan works, you have to know the following terms:

  • Index and Margin – The interest rate you pay on a hybrid ARM loan (after the introductory fixed period expires) is based on a fluctuating “index” layer plus a “margin” layer. The index is a measure of interest rates generally, and the margin is an extra amount the lender adds above the index layer. If the index rises, your interest rate will likely rise along with it. This could result in a higher monthly payment. For example, if the interest rate for the financial index is 5.5% and your margin is set at 2.25%, then the rate on your FHA ARM loan at the time of adjustment would be 7.75% (index + margin).
  • Initial Rate – We have already discussed how an adjustable-rate mortgage loan starts off with a relatively low interest rate in the beginning. This is known as the initial or introductory rate, and it will stay in place for a limited period of time — usually 1 to 5 years. Once this introductory period expires, the ARM loan can start to adjust.
  • Adjustment Period – This is just what it sounds like, the period during which your adjustable-rate mortgage adjusts to a new interest rate (and monthly payment amount). In most cases, the rate will adjust annually (once per year) after the introductory stage has expired.
  • Interest Rate Caps – These caps are an important concept in the world of FHA adjustable loans. A cap is just what it sounds like. It limits how much your interest rate can increase. ARM loan caps come in two versions: 1. Periodic adjustment caps limit how much the interest rate can go up or down from one adjustment to the next (after the first adjustment). 2. Lifetime caps limit the amount it can rise over the entire life of the loan. Lifetime caps are required by law, so you’ll find them on nearly all FHA adjustable-rate mortgage loans these days.
  • Payment Caps – Many ARMs also cap (or limit) the amount your monthly payment can increase at the time of each adjustment. So if your loan had a payment cap of, say, 8%, your monthly payment would not increase by more than 8% over your previous payment amount.

If you are considering an FHA adjustable-rate mortgage, be sure to ask your lender about the index, the margin, and any rate caps that are applied to your loan. These are the most important concepts for you to understand, because they will affect your monthly payments and the full cost of the loan.

Pros and Cons of Using an Adjustable-Rate Mortgage

There are pros and cons, advantages and disadvantages, of using an FHA ARM loan to buy a house. We’ve talked about some of the pros and cons throughout this article. Let’s revisit them briefly.

  • Pros: You could save money by securing a lower interest rate, when compared to a fixed product.
  • Cons: Your rate and monthly payments could rise, repeatedly, beyond the introductory period.

Let’s talk more about the potential for savings. Mortgage lenders usually charge lower initial interest rates for ARMs than what they charge for fixed-rate mortgage products. At first, this makes the FHA adjustable loan easier on your wallet, when compared to a fixed product for the same amount. Additionally, your FHA ARM could be less expensive over the long run, if interest rates remain steady or move lower over time.

Those are the primary advantages of using the adjustable product. But there are certain disadvantages to consider as well.

The biggest disadvantage is the risk and uncertainty. There is always a chance your rate could rise from one adjustment to the next, increasing the size of your monthly payments at the same time. This is the worst-case scenario for FHA ARM loans.

As the Federal Reserve explains it in their Consumer Handbook for Adjustable-Rate Mortgages: “It’s a trade-off. You get a lower initial rate with an ARM in exchange for assuming more risk over the long run.”

Here are three key questions to consider, before using one of these loans to buy a house:

  1. Is my income enough (or will it be enough) to cover higher monthly payments if interest rates go up?
  2. Will I be taking on other sizable debts, such as a college tuition or car loan, in the near future?
  3. How long do I plan to own this home? (If you plan to sell three or four years from now, rising interest rates may not pose the problem they do if you plan to own the house for a long time.)

Is an FHA ARM loan right for you? When does it make sense to use one? Think about your long-term plans, as well as your appetite for risk and uncertainty. You’ll find the answer within.