We could save a ton of money over the life of the loan, if we were to hold it for the remaining time.I also discovered that we would break even very quickly on the ARM, in roughly 9 months.

The only downside is the monthly PMI which you are stuck with for the life of the loan.

I have had plenty of good rentals, but please consider how things can go out of control and consume your life and money. 

Next, I read @Scott Trench - Set For Life, it really intrigued me even more about the benefits of house hacking a multi family property.

Find a good inspector that is trusted by professionals in your area and get a good pulse on the effective life of your big ticket items (Roof, HVAC, HW heater, etc.) and calculate out how much each will cost to replace, then do the math backwards for what you need to put aside for CAPex and maintenance. 

With FHA loans, the mortgage insurance is higher and will remain for the life of the loan.If you are married, best route for your plan would be to use a HomePossible, then FHA, then have your spouse do a HomePossible, then FHA.

To make everyone's life easier I definitely feel as if investing in the lines is the right thing to do.

With enough passive income to support your lifestyle, you can spend more time doing what you enjoy.

Just ask for them to put a ceiling on how much the loan can adjust for the life of the loan and how much it can jump each adjustment. 

Another thought, if you can fund it alongside the bathroom reno, might be a dormer in that section of the roof - not sure what roof style is from this photo, or what is just outside that window that might make that unappealing, but a dormer would really open up the room even if you don't make it any wider, and would give you more full-height square footage to work with.