FHA 5/1 ARM: Federal Housing Administration 5/1 Adjustable Rate Mortgage
What is the FHA 5/1 ARM?
When choosing a mortgage, there are a lot of options available to you. It can all be pretty confusing, especially when you start comparing fixed-rate and adjustable-rate mortgages. One term that you might see mentioned in loan comparisons is the 5/1 adjustable-rate mortgage (ARM). You may even see more specific references to an FHA 5/1 ARM, which is similar but a little more specific. Confused yet?
If you aren’t sure what this is or how it works, don’t worry; both the standard 5/1 ARM loan and the FHA 5/1 ARM loan are pretty simple, despite their outward appearances. They can also be very useful loans, especially if you’re a first-time home buyer or if you have plans to sell or refinance within a relatively short period of time.
What Is an FHA 5/1 ARM Loan?
First things first: A 5/1 ARM is what’s known as a “hybrid loan.” It starts out as a fixed-rate mortgage for a set period of years, and then transitions to an adjustable-rate mortgage that adjusts on a set schedule for the remainder of the loan term. In the case of a 5/1 ARM, the fixed-rate period is five years long and after that the rate adjusts every year. That’s where the “5/1” term comes from, the length of the fixed-rate period (in years) followed by the length of the period between adjustments (also in years).
To help you understand this notation, let’s imagine another hybrid loan that doubles both of the periods seen in our 5/1 ARM. That loan would have a fixed-rate period of ten years and would adjust its rate every two years after the fixed-rate period ends. That would make the loan a 10/2 ARM loan.
What Is an FHA Loan?
FHA loans are loans that are insured by the Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development (HUD). The FHA has been insuring loans and helping potential homeowners get the money they need since 1934, and the FHA loan program is available to both first-time homeowners and repeat home buyers alike.
It’s important to keep in mind that FHA loans aren’t provided by the FHA directly. Instead, FHA loans are provided by partner lenders that work to find you a better interest rate because your loan is insured by the FHA. In many cases, an FHA-insured loan will have terms that you wouldn’t be able to get otherwise due to hiccups in your credit history or other issues with your loan application. You can also typically get away with having a lower down payment on an FHA loan than what’s required for more conventional loans.
What Is the Fixed-Rate Period?
During the first five years of your FHA 5/1 ARM, the interest rate will be locked in at a rate specified in your loan agreement. The interest rate is based on the lender’s evaluation of your application and current interest-rate trends; if you borrow when other interest rates are high, then your fixed rate will be higher than they would be if you borrowed when they were low. The insurance offered by the FHA may help keep your rate at the lower end of what you qualify for, but it won’t automatically guarantee you a rate that’s lower than current mortgage rates.
The rate that you lock in remains static over the course of the fixed-rate period. Even if interest rates drop to historic lows, you’ll still be paying the same rate until the fixed-rate period ends. On the plus side, if the economy shifts and interest rates skyrocket, then you’ll still have your locked-in rate until your five-year fixed-rate period ends.
What Is an Adjustable Rate?
Once you reach the end of your fixed-rate period, the interest rate on your loan switches over to an adjustable rate. As the name suggests, this means that your interest rate can change to reflect market rates instead of being locked in at a single rate for the term of your loan. This adjustment happens once a year, giving your loan rate flexibility while still making it easy to keep track of the interest rate that you’re paying.
This adjustment can be beneficial if you took out your loan when rates were high and you’ve been locked into a higher-than-average rate during your fixed-rate period. But the adjustable rate means that you can still end up paying higher rates for a year at a time if your adjustment comes when rates are higher than normal.
What Are Rate Caps?
One important feature of the FHA 5/1 ARM is that it has rate caps in place to keep you from getting into trouble once the adjustable rate kicks in. These caps limit how much your interest rate can shift during any given adjustment. The FHA offers different rate cap structures for different ARMs, with the 5/1 ARM potentially qualifying for one of two different cap structures.
The typical 5/1 ARM is capped so that your interest rate can increase by only 1% during any year and can never get higher than 5% of what your fixed-rate interest rate was. This is the same cap structure that’s used for one-year and three-year ARMs as well. Depending on your loan provider and the details of your specific loan, your ARM could instead fall into the structure used for seven-year and ten-year ARMs. This structure allows for adjustments of up to 2% per year and a shift of up to 6% over the life of the loan.
How Do FHA Loans Help Home Buyers?
FHA loans make borrowing to own a home easier by providing extra assurance that the loan will be repaid. Because the government itself insures the loan, FHA lenders are typically able to offer better terms than they would otherwise be able to. Some homeowners might not be able to qualify for a mortgage loan at all without FHA insurance.
As mentioned, FHA loans allow for lower down payments than traditional loans; this means that you need less money up front to secure the loan. Closing costs are also lower, which helps significantly because many borrowers aren’t prepared for high closing costs when trying to purchase a home. The FHA also expands the credit range with which you can qualify for a loan, giving potential homeowners access to lower interest rates (and loans in general) even if they have less-than-perfect credit.
In addition, FHA programs may allow borrowers to include in their loans other costs such as the cost of home improvements and materials to make the home more energy-efficient. Though additional assessments are required to make sure that the improvements are cost-effective and that the home uses enough energy to make the upgrades worthwhile, the programs can cover improvements ranging from new doors and windows to solar installations that reduce overall energy costs.
Are FHA 5/1 ARM Loans for First-Time Home Buyers?
Because FHA 5/1 ARMs often reduce the amount needed for a down payment and can offer lower interest rates as well, first-time home buyers commonly apply for FHA loans. But this doesn’t mean that only first-timers are eligible for them. The FHA has programs available to help a wide range of individuals, regardless of whether they have owned a home before or not.
How Do You Get an FHA Loan?
Applying for an FHA loan such as the 5/1 ARM isn’t as straightforward as applying for more traditional loans. There are extra steps involved, but they are an important part of making sure that your loan is secure to get you the best terms possible.
The first thing that you have to do is use an FHA lender, who will likely walk you through the steps of applying for FHA insurance and securing your loan. You must intend to use the purchased property as your primary residence and will need a down payment of 3.5% to 10% of the amount borrowed depending on your credit score. The property itself will have to be appraised by an FHA-approved appraiser and meet guidelines set by HUD.
Once your loan is approved, you will have to pay closing costs (though the FHA limits these to no higher than 3% to 5% of the loan amount). You will also have to pay an upfront mortgage insurance premium of 1.75% (which can be included in the borrowed amount) and an annual premium of between 0.45% and 1.05% of the loan amount, divided by 12 and paid monthly.
Is an FHA 5/1 ARM Right for Me?
The FHA 5/1 ARM loan is a good choice for many home buyers, but it isn’t right for everyone. To determine whether it’s right for you, it’s important to think about whether you qualify for FHA assistance and what your plans are for the property you want to buy. Talk with an FHA lender or visit the FHA website to find out more about the specific qualifications for FHA loans in your area.
You also need to consider whether the 5/1 adjustable-rate strategy best fits your financial situation and long-term plans. Don’t be afraid to talk with a financial adviser or loan specialist to see if this is the loan option that’s best for you. A mortgage is a big commitment, and finding the right mortgage for your needs is an important part of making your dream of home ownership a reality.