Mortgage insurance offered by the Federal Housing Administration can remove many of the obstacles to home ownership. This insurance protects a lender from losing money if you fail to pay on a loan. With FHA mortgage insurance, you only have to front a small amount, as low as 3.5 percent of the price of the home. The Federal Housing Administration insures 30-year, fixed-rate mortgages and certain adjustable-rate mortgages, such as those whose rates start changing after the first five years. Choosing whether to go with the five-year adjustable loan or the 30-year fixed loan depends upon how much certainty you want in your budget, how much house you want and what you can pay on a mortgage.
The interest rate in a five-year FHA loan stays the same for the first five years. Starting in year six, the rate moves up or down with an index based upon the interest a person would get from owning U.S. Treasury Securities. The Federal Housing Administration limits annual increases to two percentage points and increases through the loan's life to six percentage points. This means that if you took out the loan at four percent, you pay four percent interest for the first 60 months. Afterwards, your interest rate can never jump above 10 percent as long as you have the loan. With a 30-year FHA loan, your interest rate never changes.
The 30-year FHA mortgage brings you certainty. Because rates do not change, your monthly principal and interest payments stay constant. Changes in property taxes and mortgage insurance costs might move your monthly mortgage payments slightly. Planning your budget proves somewhat more challenging with a five-year mortgage. After five years, you don't know what the interest rate will be or what you'll pay each month. If rates go up, you'll have higher mortgage payments, which means less money for vacations, buying a new car, keeping up your home or paying off other debt. However, because FHA caps interest rate rises each year and over the life of the loan, a five-year FHA mortgage will not take you on a roller coaster ride.
You might get more house with a five-year FHA loan than a 30-year loan. What you can borrow depends upon the mortgage payment, your other debt and your income before taxes. FHA limits your mortgage payment to 31 percent of your gross income; your mortgage payment plus your other debts cannot top 43 percent of your gross income. According to the National Foundation for Consumer Counseling, adjustable rate mortgages allow for larger loans because the initial rates are lower than fixed-rate mortgages. You get a smaller loan with a 30-year FHA loan because your monthly mortgage payments are higher.
Choosing the Better Alternative
Take the five-year FHA loan if you plan to refinance or move after five years in the home. Since rates and payments can go up after five years, consider whether you think you'll have more money because of a higher-paying job, profits from selling property or an inheritance. If you are not confident your income will rise, opt for the fixed mortgage rather than plunging into the adjustable rate.
- United States Department of Housing and Urban Development: Federal Housing Administration: Adjustable Rate Mortgage
- The Federal Reserve Board: Consumer Handbook on Adjustable-Rate Mortgages
- Code of Federal Regulations: 29 C.F.R. Section 203.49
- North Carolina State University: North Carolina Cooperative Extension Service: "A Home for Your Family: Choosing the Best Mortgage"
- United States Department of Housing and Urban Development: HUD 4155.1: Chapter 4: Section F: Qualifying Ratios
- United States Department of Housing and Urban Development: Insurance for Adjustable Rate Mortgages (Section 251)
- United States Department of Housing and Urban Development: Federal Housing Administration
- United States Department of Housing and Urban Development: Homebuying: Common Questions for First-time Homebuyers
- United States Department of Housing and Urban Development: Adjustable Rate Mortgages (ARMs) (Section 251)
- City of Seattle: Office of Arts & Cultural Affairs: Square Feet Seattle
- United States Department of Housing and Urban Development: Streamline Your FHA Mortgage
- United States Department of Housing and Urban Development: 203(b) Mortgage Insurance
Christopher Raines enjoys sharing his knowledge of business, financial matters and the law. He earned his business administration and law degrees from the University of North Carolina at Chapel Hill. As a lawyer since August 1996, Raines has handled cases involving business, consumer and other areas of the law.