What is an FHA 5-year ARM loan and how does it work? What are the advantages or benefits of using an FHA 5/1 ARM loan, versus the more common 30-year fixed? Is an adjustable-rate mortgage the right choice for me?
These are some of the most common questions home buyers and mortgage shoppers have about the FHA 5-year ARM loan option.
We’ve covered the topic of adjustable rate mortgages in previous blog posts. Today, we’ll zero in on the FHA 5/1 ARM in particular. Here’s what you should know about this unique financing strategy, in order to make an informed decision.
FHA 5-Year ARM Loans Explained
Let’s start by covering some basic terminology relating to the FHA 5-year ARM loan:
FHA stands for Federal Housing Administration. This government agency falls under the Department of Housing and Urban Development (HUD). Through their mortgage insurance program, the FHA insures home loans that are originated by lenders in the private sector. The insurance protects the lender in cases where the borrower stops paying or “defaults.” These products are commonly referred to as FHA loans.
ARM stands for adjustable-rate mortgage. This type of loan has an interest rate that changes, or “adjusts,” over time. In most cases, the rate will adjust annually, following an introductory period where it remains fixed. For example, the 5/1 ARM mentioned above has a fixed rate for the first five years, and then changes every one year after that.
Note: You might see this type of mortgage product referred to as an “FHA 5-year ARM” or an “FHA 5/1 ARM.” The two terms are generally interchangeable. They both refer to a government-insured adjustable-rate mortgage loan that remains fixed for the first five years and changes annually thereafter.
With that primer out of the way, let’s talk about how the FHA 5/1 ARM loan actually works.
How This Financing Option Works
As mentioned earlier, an adjustable-rate mortgage loan has an interest rate that adjusts periodically over the term or “life” of the loan. The rate can adjust up or down, depending on the “index rate” it’s connected to (such as the Constant Maturity Treasury index).
In contrast, a fixed FHA loan carries the same interest rate for the entire term, even if it’s a full 30-year term.
This is one of the biggest decisions you’ll have to make when shopping for an FHA loan. Do you want to use a fixed-rate mortgage (FRM) or an ARM?
Most of the FHA ARM loans in use today start off with a fixed interest rate for a certain period of time. This is known as the initial or introductory period, and it can last anywhere from one to seven years in most cases. The FHA 5-year or 5/1 ARM loan is a good example of this.
During this initial stage, the interest rate on the loan will remain fixed and unchanging. So, essentially, it behaves like a standard fixed mortgage — for the first few years.
But after the initial phase expires (and this is the most important thing to understand) the FHA ARM loan will reach its first adjustment period. This is when the rate can change, possibly increasing the size of the monthly payments.
Why They’re Known as ‘Hybrid’ Loans
This type of loan is often referred to as a “hybrid,” since it has both a fixed and adjustable stage.
Hybrid mortgage products are usually labeled with numbers that describe how they adjust over time. Consider the 5/1 FHA ARM loan, for example. The first number pertains to the initial period where the rate remains fixed. The second number tells you how often the rate will change (in years) following the initial phase.
In the case of the FHA 5/1 ARM loan, the numbers tell us that it starts out with a fixed rate for the first five years of the term, after which the rate will adjust (or “reset”) once every year.
According to the Department of Housing and Urban Development:
“FHA offers a standard 1-year ARM and four ‘hybrid’ products. Hybrid ARMs offer an initial interest rate that is constant for the first 3, 5, 7, or 10 years. After the initial [fixed] period, the interest rate will adjust annually.”
Potential Benefits of a 5-Year FHA ARM
At this point, you might wonder why anyone would want to use an FHA 5-year ARM loan when buying a home. What’s the advantage of using a 5/1 adjustable mortgage over the more popular 30-year fixed?
The answer has to do with savings.
ARM loans typically (but not always) start off with a lower interest rate, compared to the longer term 30-year fixed mortgage. At least, during the initial stage. So a home buyer could use an FHA 5/1 ARM loan and enjoy a lower interest rate during those first five years. That could be a real money-saver.
Of course, after those first five “introductory” years, the mortgage rate could change or reset upward. So there’s some long-term uncertainty when using an FHA 5-year ARM. Like most mortgage products, there are pros and cons to consider.
Many borrowers use the adjustable mortgage option as a way to save money during the first few years, with the intention of refinancing into a fixed loan later on. So that’s another strategy worth considering.
Four Parts of an Adjustable-Rate Mortgage
Every FHA ARM loan has four main components or parts:
- an index
- a margin
- an interest-rate cap structure
- an initial interest-rate period
When the initial (fixed) phase expires, the new interest rate will be calculated by adding a margin to the index. You can think of the index as the “baseline” rate, and the margin as a “markup” above the base. Your FHA mortgage lender should tell you the margin when you apply for the loan. Margins on FHA ARM loans can vary from one lender to the next, so you’ll want to shop around for a low margin.
These days, most of the FHA adjustable-rate mortgages are associated with one of two indexes. They are usually tied to the Constant Maturity Treasury (CMT) index, or the 1-year London Interbank Offered Rate (LIBOR). As the related index moves up or down, your mortgage interest rate will be adjusted accordingly.
The All-Important Rate Cap
Rate caps are one of the most important concepts for borrowers to understand, because they affect the magnitude of the interest rate adjustments. The cap structure on an FHA 5-year ARM loan will limit how much the interest rate can increase or decrease over time.
Interest rate caps for adjustable mortgages are designed to shield borrowers from unusually large rate fluctuations. There are two main types of caps: (1) annual, and (2) life-of-the-loan. As you might have guessed, the annual cap limits the amount your interest rate can change, up or down, within a given year. The life-of-the-loan cap “limits the maximum (and minimum) interest rate you can pay for as long as you have the mortgage,” according to HUD.
So there you have it, a breakdown of the FHA 5/1 ARM loan, how it works, and the pros and cons of using this strategy.
Disclaimer: This articles provides a general overview of the adjustable-rate mortgage and related topics. It is not meant to be an exhaustive or all-inclusive lesson. Additionally, portions of this article might not apply to your particular situation. We encourage you to conduct thorough research into your home loan options, before making any decisions.