If you are only going to live on a property for 10 years, a 30-year mortgage might be overkill. That’s where adjustable rate mortgages — or ARMs — come in.
Unlike a fixed-rate mortgage, the interest rate on an ARM can change. It can go up and down depending on the interest-rate benchmark it is pegged to.
The initial interest rate of an ARM is nearly always lower than that of a fixed-rate mortgage. “It helps you with affordability because the payment is lower. That makes it a product that is very appropriate for a first-time homebuyer,” said Tendayi Kapfidze, chief economist for LendingTree, which is owned by MagnifyMoney.
First-time homebuyers may also find ARMs — especially those guaranteed by the Federal Housing Administration or FHA, an agency of the federal government — particularly easy to qualify for. These loans are financed by FHA-approved private lenders, but the FHA guarantees that the lenders will get their money even if a borrower fails to pay. Because FHA backing reduces the risk to lenders, they are more likely to approve loans to borrowers who don’t have great credit or who just lack a long credit history. Kapfidze explained, “FHA loans have different borrower requirements. You need less of a down payment. You can qualify with a lesser credit score. An FHA loan is generally more accessible than a conventional loan.”
What borrowers need to know to make a smart decision
It’s true that FHA ARMs — and ARMs in general — can be more complicated and have more moving parts than conventional fixed-rate mortgages. That means the first thing someone who is considering one has to do is study the nitty-gritty of the ARM or ARMs until he or she understands what they’re getting themself into. “You really have to understand the product and the responsibility you are taking on,” Kapfidze said.
Here are some basics about how FHA ARMs work.
An ARM has four primary parts to consider:
- Index. The index is how the rate will be set. FHA-insured ARM loans are generally pegged to either the Constant Maturity Treasury (CMT) index (“weekly average yield of U.S. Treasury securities, adjusted to a constant maturity of one year”); or the one-year London Interbank Offered Rate (Libor), which is the rate banks set daily when they lend to each other.
- Margin. This is the number of percentage points added to the index by the lender that generally represents the lender’s profit. The borrower and the lender can negotiate on this amount.
- Initial interest rate period. Generally, the interest rate on on FHA ARM is calculated by adding together the rate and the margin. The period that the initial loan rate remains in effect without changing is the initial interest-rate period. After that, the interest rate can go up or down based on what happens to the index and sometimes other factors.
- Interest rate cap. The cap limits how much the interest rate can go up or down when the index changes. This protects you from big swings in your payment amount.
FHA allows lenders to offer a standard one-year ARM and four “hybrid” ARMs, whose interest rates hold steady for set periods of time and then adjust annually.
- A 1-year FHA ARM can rise (or lower) up to 1 percentage point annually after the first year. It can rise (or lower) a maximum of 5 percentage points over the life of the loan.
- A 3-year FHA ARM rates can rise (or lower) up to 1 percentage point annually after three years and exceed (or decrease from) the initial rate by a maximum of 5 percentage points over the life of the mortgage.
- 5-year ARMs offer two options. They can increase (or decrease) by up to 1 percentage point annually, and by 5 percentage points over the life of the mortgage. Or they can increase (or decrease) up to 2 percentage points annually and up to 6 percentage points over the life of the loan.
- 7- and 10-year ARM rates can increase (or decrease) by up to 2 percentage points annually after the initial fixed interest-rate period. They are capped at 6 percentage points over the starting rate.
Here’s how a 5-year ARM with an annual adjustment might work: The 5/1 FHA ARM is fixed for the first five years at, perhaps, 3% in today’s market. That compares favorably with a 30-year fixed-rate mortgage, which in today’s market would be about 4.50%. For a $200,000 mortgage, that would save $170/month. After five years, or 60 months, the interest would adjust annually based on an index (1-year Libor or 1-year Treasury/CMT), plus a margin of somewhere between 2.25% and 2.75% at most lenders. According to Kapfidze, “There is also an annual and lifetime cap on the interest rate changes. The rate can also adjust downwards.”
What are the benefits of an FHA ARM?
Compared with a fixed-rate mortgage, an FHA ARM can be a bargain. LendingTree’s Kapfidze bought his first home with an ARM. The rate adjusted downward and saved him money because the payments turned out to be lower than he had expected when he bought the home.
Even if FHA ARM payments adjust upward, they rise at predictable intervals, and that gives a borrower time to adjust financially. FHA ARMs are particularly worthy of consideration when:
- You know you aren’t going to live on the property for longer than the fixed-rate period;
- You’re confident that your income will rise;
- You have wiggle room in your budget, so you can absorb an interest-rate increase;
- In a pinch, you have the wherewithal to refinance out of the FHA ARM into another ARM or a fixed-rate mortgage — or you will be able to pay the mortgage off.
What are the disadvantages of an FHA ARM?
Mortgage insurance for the life of the loan. FHA loans require borrowers to pay a 1.75% upfront fee and a mortgage insurance premium (MIP) annually — unless you put at least 10% down, then you pay for 11 years. Borrowers with less than 5% down on a 30-year mortgage pay annual MIP of 0.85%.
Most of us don’t have a crystal ball to predict interest-rate changes. “We have had a couple of years of rising rates, and we may see more rising rates,” said Kapfidze, whose job includes predicting these fluctuations.
What about the turmoil that roiled some borrowers with ARMs during the recession of 2007 to 2009? “The economy is complex, but I wouldn’t be looking at 2008 (the year the Case-Shiller Home Price Index collapsed in advance of the Great Recession) as an analogy for today,” Kapfidze said. “Today’s lending standards are much more stringent. We don’t have the aggressive lending we had going on then. We are in very different circumstances.”
Who should consider an FHA ARM? Housing-market beginners, for one. Kapfidze explained, “You need less of a down payment — a minimum of 3.5%. You can qualify for a lesser credit score — 580. FHA loans are just more accessible.”
This article contains links to LendingTree, our parent company.