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Reader question: “We are thinking about using an FHA loan due to the 3.5% down payment option. We also want to use a 5/1 adjustable-rate mortgage because we will only live in the home for about three years, or four at the most. So I have two questions. Does the FHA offer adjustable mortgage products? And if so, how does an FHA ARM loan work? Does it work just like a regular kind of ARM?”

Let me give you some quick answers, and then we’ll expand from there:

  • The Federal Housing Administration does not “offer” loans — they only insure them.
  • The mortgage product itself is offered by a lender in the private sector.
  • FHA-insured home loans are available in both fixed-rate and adjustable-rate formats.
  • For the most part, an FHA ARM works just like a conventional ARM, as explained below.

And for those who aren’t familiar with the terminology being used here:

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. These products are 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 in the reader’s question above has a fixed rate for the first five years, and then changes every one year after that. Hence the 5/1 designation.

So let’s circle back to the root of your question: How do FHA ARM loans work?

Here’s How an FHA ARM Loan Works

An FHA ARM loans has an interest rate that adjusts periodically over the term or “life” of the loan. The rate can adjust up or down, depending on bond prices and other economic conditions. 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.

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 — and possibly increase the size of the monthly payments.

This type of loan is often referred to as a “hybrid,” since it has both a fixed and adjustable stage.

These mortgage products are often 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, after the initial phase.

In the case of a 5/1 ARM, 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. That’s what the “5/1″ label signifies.

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.”

Four Parts of an Adjustable-Rate Mortgage

Every FHA ARM loan has four main components or parts. They have: (1) an index, (2) a margin, (3) an interest-rate cap structure, and (4) 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 will 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 your loan will limit how much the interest rate can increase or decrease over time.

The interest rate caps on an FHA ARM loan are designed to shield borrowers from unusually large rate fluctuations. There are two 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.