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FHA 5/1 ARM or FHA 30 Year Loan
A Common Home Mortgage Loan Question
A first-time home buyer couple is trying to decide between an FHA 5/1 ARM (Adjustable Rate Mortgage) at 4.25% with a 9% lifetime cap (30 year loan) and an FHA fixed rate for 30 years at 5.25%.
The loan amount is $150,000 (purchaser put down 5%) and they note that the difference in monthly payments is about $90 in favor of the FHA 5/1 ARM. They have income that they anticipate will go up considerably and plan on moving within 5 years.
Both the FHA and the 30 year fixed rate and FHA 5/1 ARM are easily affordable for them. They think that with a fixed they will save over $5,400 over the next 5 years which they consider will be used as a down payment when they move.
With an FHA 5/1 ARM the ARM has a 6.25% cap the 6th year with a 1% per year maximum increase---i.e. 7.25% cap the 7th year and an 8.25% cap the 8th year and the maximum cap of 9% from years 9 through 30.
As a first-time home buyer many people balk at the idea of a person considering the ARM.
However in some situations it may be appropriate. Therefore it is important that a real estate agent not only listens carefully but also possesses the know-how to analyze the situation of the buyer(s) properly.
Based on the above scenario the questions that must be asked and answered include:
1) Q: Will you be obtaining the loan jointly or will only one of you be on the loan?
A: Although my spouse works, I will be obtaining the loan in my name only but will title the property in both of our names.
2) Q: Do you qualify for the loan individually and what percent of income does it represent?
A: Yes, I have been pre-approved for the loan in the amount of $150,000 in my name only. It is 24% of my income excluding the car payment of $420 per month.
3) Q: Do you have an adequate emergency fund?
A: I have a greater than 6 month emergency fund based on my finances after the purchase of the house whether I utilize the 5/1 FHA ARM or The 30 year fixed.
4) Q: Do you have other income sources or any other compensating factors that may affect your loan?
A: My wife has income of about 60% of my income and our debts other than our housing only consists of a car payment of $420 per month.
5) Q: Have you done a worst case scenario analysis?
Based on the above Q and A an amortization schedule of 150K @ 4.25% with the FHA 5/1 ARM revealed a monthly payment of principal and interest of $735 per month.
The FHA 30 year fixed rate @ 5.25% revealed a monthly payment of $825 per month.
The difference in payment is $5,400 over a 5 year (60 month) period. However there is also a difference in the principal amount owed at the end of 5 years due to the lower interest rate on the FHA 5/1 ARM and hence a lower principal balance remaining which equates to more equity for the purchaser.
The principal is reduced by $13,615 with the FHA 5/1 ARM and $11,529 with the FHA 30 year fixed rate mortgage which is a difference of $2,090 in favor of the FHA 5/1 ARM.
You then add the $5,400 and $2,090 to get $7,490 which means the FHA 5/1 ARM will put the purchaser ahead at least $7,490 if all things were to remain constant.
However in real estate things seldom remain constant.
Property Taxes, Hazard Insurance and Private Mortgage Insurance has not been factored in. In addition we do not know with certainty that the price will appreciate or depreciate over the next 5 years.
Appreciation or depreciation of the property would increase or decrease the above figure of $7,490.
Properly shopping for a home will help mitigate the chance of a substantial fall in value. Even though the purchasers job appears secure, that may not be the case in the future.
From this scenario and based on the facts of the situation and the purchasers intended move in 5 years it appears that the FHA 5/1 ARM is the better choice and would be the one that I would recommend based on their current situation.
Their housing versus income is well below 31% and their housing plus debt versus income in either scenario is well below 43%. They have the ability to handle unforeseen circumstances and maintain their home in either scenario.
Although I am not a huge proponent of ARM’s in general, I realize that they can be of benefit to some people in the right situation.
Therefore it is imperative that you work with an agent who will ask the right questions when you are in the process of purchasing your first home or any home.
In addition I would perform scenario analysis in the unexpected case that they would have to sell early or sell at a later date (after 5 years) as life events can occur rather unexpectedly and by performing analysis ahead of time the purchaser can better prepare for their future.
A Conventional 5/1 ARM and A Conventional 30 year fixed rate loan would require a similar comparison with some slight differences.
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About This Article:
The above article was written by Thomas (TJ) Underwood. Thomas (TJ) Underwood is an active real estate broker in the state of Georgia and is the writer behind The Wealth Increaser, Home Buyer 411, Home Seller 411, The 3 Step Structured Approach to Managing Your Finances, Managing & Improving Your Credit & Finances for this MILLENNIUM and CREDIT & FINANCE IMPROVEMENT MADE EASY—FREE GUIDE.
He is the creator of TheWealthIncreaser.com where he regularly blogs about helping consumers improve their credit, finance and real estate pursuits in an intelligent, consistent and proactive manner. He’s always looking for ways to make intelligent finance improvement happen for those who “sincerely desire” success in their future.
You can contact him from a number of sources but the most direct way is to contact him through the contact us block that can be found at the bottom of this page.
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