The ARM That Looked 'Basically the Same'
A 58-year-old self-employed borrower is purchasing a $525,000 condominium with 20% down, producing a $420,000 loan. FICO is 740 and total DTI is 40%. The borrower plans to retire in five years and has no other debt. The broker offers a 7/1 ARM at 6.25% with 2/1/5 caps, a 2.75% margin, and a fully indexed rate of 7.375%. The lifetime cap is 11.25%. A 30-year fixed is available at 6.75%. The borrower says, "Put me in the ARM to keep the payment low; I'll sell or refinance before it adjusts." The broker's compensation is 0.5% higher on the ARM, and the broker tells the borrower the ARM is "basically the same" because the initial payment is lower.
1. At what rate should the borrower be qualified, and what payment shock should be disclosed? Explain the reasoning.
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The borrower should be qualified at the greater of the note rate or the fully indexed rate. Here the note rate is 6.25% and the fully indexed rate is 7.375% (index plus 2.75% margin), so qualification should use 7.375%, not the promotional 6.25%.
On a $420,000 30-year loan, principal and interest at 6.25% is about $2,585 per month. At 7.375% it is about $2,900 per month, roughly $315 more before taxes and insurance. That is the payment shock the borrower needs to see. The broker should also show the effect of the 2% initial adjustment cap, the 1% subsequent cap, the 5% lifetime cap, and the 11.25% maximum rate. If the loan is underwritten under a QM/ATR standard, the creditor should also apply its required maximum-rate test for the early years. Qualifying only at the start rate would understate the borrower's obligation and could hide a payment the borrower cannot sustain after retirement.
2. What ethical and suitability issues arise from the broker's compensation and statement, and what should the broker do?
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The broker has a conflict because the ARM pays 0.5% more. That does not prohibit offering the ARM, but it requires extra care. Calling the products "basically the same" is misleading: the ARM transfers interest-rate risk to the borrower after seven years, has caps and a margin, and could adjust sharply. The broker should not steer the borrower toward the higher-compensation product based on the broker's pay or on an unsupported claim that refinancing or selling will solve the risk.
The broker should present both the ARM and the fixed loan in writing, compare initial and fully indexed payments, show worst-case adjustment scenarios, and ask about retirement income, plans to sell, and ability to absorb a higher payment. The borrower's stated preference should be documented, but it must be informed. The broker should disclose the compensation difference if required by applicable law and should not discourage the borrower from considering the fixed loan. The file should show that the borrower received the ARM disclosures and understood the caps, margin, index, and lifetime maximum.
3. If the borrower insists on the ARM after receiving the comparison, may the broker proceed?
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Yes, the broker may proceed if the borrower is eligible, the loan can be underwritten at the appropriate qualifying rate, required disclosures are given, and the borrower makes an informed choice. The broker should not override the borrower's decision merely because the broker prefers a different product. However, the broker should document the comparison, the borrower's reasons, and the borrower's acknowledgment of the adjustment risk.
The broker should also confirm that the borrower's retirement income and reserves were considered. If the file shows the borrower cannot qualify at the fully indexed rate or would be unable to handle the adjusted payment, the broker should not paper over that fact. The appropriate response is to explain the risk, offer alternatives, and let underwriting make its independent decision.