FHA ARMs: A Better Deal

by Gina Pogol
June 24th, 2010

If you’re a first-time home buyer, you probably won’t keep your new home more than a few years. So why pay a higher interest rate than necessary? FHA ARMs and hybrid ARMs offer low interest rates, plus protections that ordinary ARMs don’t. To understand the advantage of FHA ARMs over ordinary ARMs, you first need an idea of how ARM rates work.

An ARM has five terms you need to understand: index, margin,  rate caps, the start rate, and initial interest rate period. When the initial interest rate period has expired, the new interest rate is determined by adding a margin (which you negotiate with your lender) to a published financial index like the CMT or LIBOR.
The interest rate caps supply some protection from wild interest rate changes. There are two types of caps: adjustment and lifetime. The adjustment cap limits the extent that your interest rate can change, up or down, at any single adjustment, while the lifetime cap limits the maximum interest rate you can pay.

FHA ARMs come in the standard 1-year ARM and four hybrid models. Hybrid ARMs offer an initial interest rate that is constant for the first 3-, 5-, 7-, or 10 years. After the initial period, the interest rate adjusts annually. Below are the different interest rate cap structures for the various ARM products:

* 1-year ARM and 3-year hybrid ARM have adjustment caps of one percentage point, and lifetime caps of five percentage points. (Example – if your initial interest rate were 3%, the highest possible interest rate would be 8%.) Conventional ARMs come with 2% annual caps and 6% lifetime caps, making them less safe than FHA ARMs.
* 5-, 7-, and 10-year hybrid ARM come with adjustment caps of two percentage points (after the initial rate period expires), and lifetime caps of six percentage points.

FHA ARMs also confer the other advantages of FHA loans — 3.5% down payments, flexible underwriting guidelines, and the ability to streamline refinance into either another ARM or a fixed-rate mortgage with no appraisal or credit qualifying. Finally, FHA mortgages are assumable, and in if interest rates have increased by the time you wish to sell your home, an assumable loan at a lower rate could give you a competitive advantage over other home sellers in your area.

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