Interest-Only ARM for a Fixed-Income Refinance
Elena, age 58, applies for a $420,000 refinance of her primary residence in Worcester. She has 12 years left on a fixed pension and Social Security totaling $4,100 per month. Her current mortgage is a 30-year fixed at 4.25% with 24 years remaining; payment $2,065 P&I. Elena wants a lower payment to help pay medical bills. The MLO, Kevin, proposes a 5/1 ARM: 3.25% introductory rate for 60 months, fully indexed rate 7.00%, 2/2/5 caps, $420,000 loan, 30-year term, interest-only for first 5 years. The fully indexed P&I would be about $2,794; interest-only payment about $1,138. Kevin says “you can refinance before the rate adjusts.” Elena’s DTI using the fully indexed payment and other debts is 54%; using the teaser payment it is 47%. She plans to stay in the home at least 10 years.
1. Is the 5/1 interest-only ARM suitable for Elena, and what underwriting standard applies?
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The proposal is not suitable on these facts. Elena is 58, lives on fixed income, has medical bills, and plans to stay in the home at least 10 years. The loan lowers the current $2,065 payment only by using a 3.25% teaser and interest-only payments of about $1,138. At the fully indexed rate of 7.00%, the amortizing payment is about $2,794-well above her current fixed payment. The 2/2/5 caps do not protect her from the first adjustment risk, and the statement that she can refinance later is not a repayment source. Under the ATR/QM rules, the lender must underwrite using the maximum rate during the first five years and amortizing payments, not the teaser or interest-only payment. Even using the higher fully indexed rate, her DTI is 54%; the teaser DTI of 47% is not the qualifying standard. An interest-only ARM is not a QM, so the lender must document ATR carefully. She should compare a fixed-rate refinance, a smaller cash-out amount, or no cash-out; if she needs $200,000 to gift to family, she should receive independent advice about the risk of losing the home.
2. What disclosures and documentation should Kevin provide if Elena still wants to proceed?
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Kevin must provide the ARM disclosures, including the Consumer Handbook on Adjustable-Rate Mortgages (CHARM) and the loan program disclosure, the interest-only disclosure explaining payment shock, the Loan Estimate and Closing Disclosure, and the TILA rescission notice for a refinance. He must document income, debts, assets, credit, and the basis for any ATR conclusion. If the loan is not QM, the file should show the underwriting at the maximum first-five-year rate and amortizing payments, not the teaser. He should document that Elena received the payment examples and understood the fully indexed payment, the 2/2/5 caps, the interest-only period, and the lack of a guaranteed refinance. He should also document any discussion of alternatives and her stated goals. A signed statement that she can refinance later is not adequate; the file needs verified ability to repay. Given the 54% DTI, Kevin should escalate to compliance before proceeding.