June 30, 2022

Factors That Affect Rate Changes On FHA Adjustable Rate Mortgages

The FHA offers a variety of different adjustable rate mortgage (ARM) programs (see Different Types of FHA Adjustable Rate Mortgages).

Each borrower has unique needs to consider when deciding whether to take an FHA ARM or an FHA fixed rate mortgage product.  Both the fixed and adjustable rate mortgages have benefits and risks and a careful consideration of which product to chose is necessary.  For some borrowers, an FHA ARM offers significant savings since the interest rate is lower on FHA ARM mortgages.  The offset to the lower interest rate is the risk that the borrower may pay a significantly higher interest rate at some point in the future (see Benefits and Risks of FHA Adjustable Rate Mortgages).

Once the decision is made to go with an FHA ARM, the borrower needs to understand the underlying mechanism by which the interest rate can change.  The FHA offers a choice of five different ARM products that allows the borrower to chose the one best suited to match the period of time that the borrower expects to remain in the home and the level of interest rate change risk that the borrower is prepared to accept.

Before selecting a particular FHA ARM mortgage product, the borrower needs to understand exactly what factors are involved when the interest rate on an FHA ARM mortgage changes.

To understand how the interest rate can change on an FHA ARM mortgage after the initial fixed rate period has expired, a borrower needs to understand two fundamental components of the interest rate structure of an ARM, which are the 1) Index and 2) the Margin.  The sum of the margin and the index will determine the new rate when an FHA ARM adjusts.

The margin on the FHA ARM is determined when your loan is first taken out and does not change over the life of the loan.  Margins can vary from lender to lender and are one of the most important factors in determining the interest rate on an FHA ARM, so a smart borrower will shop around for the lowest margin.  The lender is required to disclose the margin on an ARM to the borrower at the time of loan application.

The index is the variable portion of an FHA interest rate and is based on market interest rates.  The index will not vary from lender to lender.  The FHA allows the use of only two interest rate indexes, either the Constant Maturity Treasury Index (CMT) or the 1 year LIBOR (London Interbank Offered Rate).  Both the CMT and LIBOR constantly vary based on market changes in interest rates.  Both indexes are currently at very low levels which is why current FHA ARM rates are so low.  The 1 year treasury is at 0.16% and the LIBOR is at 0.72%.  At the date upon which the FHA ARM adjusts, the sum of the borrower’s margin and index will determine the new interest rate on the loan.

FHA ARM mortgages are all subject to annual and lifetime caps, as summarized below.

FHA Adjustable Rate Mortgages
Type Annual Cap Life of loan Cap
1 Year ARM 1% 5%
3 Year ARM 1% 5%
5 Year ARM 2% 6%
7 Year ARM 2% 6%
10 Year ARM 2% 6%