Qualifying the 5/1 ARM She Was Quoted
Your borrower is a 52-year-old project manager with a $114,000 base salary. She received a documented $12,000 bonus in each of the last two years, and her employer states in writing that bonuses are likely to continue. She has one $650 car payment and no other debt. She is under contract on a $500,000 condo and wants 20% down, producing a $400,000 loan. She has been quoted a 5/1 ARM: 6.000% note rate for the first 60 months, 2/2/5 caps, a 2.750% margin, and a 30-day index currently at 4.550%. Monthly property charges are $520 taxes, $110 insurance, and $150 HOA. The 30-year fixed she also qualifies for is priced at 6.750%. Her stated reason for choosing the ARM is that "the payment is about $340 lower," and she plans to sell or refinance in roughly four years. Your pricing engine displays the ARM at the teaser rate. Your investor caps total DTI at 43% for this product and requires compliance with the general ability-to-repay standard.
1. At what interest rate must she actually be qualified, and what do the numbers show?
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The teaser rate is not the qualifying rate. The fully indexed rate is index 4.550% + margin 2.750% = 7.300%. Because this is a discounted variable-rate loan, ability to repay must be measured using the fully indexed rate rather than the 6.000% introductory rate. The caps do not soften this: with a 60-month initial period, the first adjustment occurs in year six, outside the five-year lookback used when a loan has a shorter initial fixed period, so 7.300% is the number.
Payment math on $400,000, 360 months:
- 6.000% (teaser): principal and interest $2,398; housing $3,178; total debt $3,828; DTI 40.3% of $9,500 monthly income.
- 7.300% (fully indexed): principal and interest $2,742; housing $3,522; total debt $4,172; DTI 43.9%.
The ARM fails your investor's 43% cap at the rate that must be used, even though it sails through at the rate she was shown. The bonus income is usable - two years of documented receipt plus an employer likelihood statement - but it is already inside the $9,500. The gap here is roughly $344 of housing payment, so no reasonable reading of the bonus gets the ARM under 43%.
2. Compare the ARM with the fixed option and evaluate whether the ARM is genuinely in her interest.
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Run the fixed rate through the same math: 6.750% on $400,000 gives principal and interest of $2,594, housing of $3,374, total debt of $4,024, and a DTI of 42.4% - inside the 43% cap.
So the loan she wants is the one that does not qualify, and the loan she dismissed is the one that does. The "$340 lower payment" is measured against a rate that exists for 60 months and then resets to an index plus a 2.750% margin with no cap protecting her at the first adjustment beyond 2.000%.
Her four-year horizon does not rescue the choice. The ARM's payment advantage exists only if she sells or refinances on schedule; if the sale slips or rates are unfavorable at refinance, she is exposed to a 2.000% first-adjustment cap. Refinancing also carries its own closing costs that her break-even analysis has not counted. And because the ARM fails the DTI test outright, the discussion is somewhat moot: at the fully indexed rate there is no approval to compare.
Her stated goal - lowest cost over four years - is better served by a loan she can actually obtain and hold, and by a conversation about whether $500,000 is the right price point at 20% down.
3. What must you tell her and document before she chooses?
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Document the qualifying analysis, not just the outcome. The file should show the fully indexed rate calculation (index + margin), the amortization at the qualifying rate, the DTI at both rates, and the investor's 43% cap. That record is what protects you if the file is later examined against the ability-to-repay standard, and it is also what would refresh when you re-priced the fully indexed rate.
Disclosures: the ARM application disclosure and the Consumer Handbook on Adjustable-Rate Mortgages must be given at application, and the disclosure must state the index, margin, caps, and the fact that her payment can rise. Do not present the teaser payment as "the payment" in any written or verbal comparison.
In the conversation, be direct that at the current index she does not qualify for the ARM at this loan amount, and explain the fixed alternative at 42.4%. Offer the concrete choices: bring more cash to closing to shrink the loan, reduce the purchase price, or take the fixed. Finally, record the borrower's decision and date it - if she chooses the fixed, note that she was shown the ARM and why it was unavailable; if she chooses to restructure, note what changed.