A 7/1 ARM at the Ceiling: Payment Shock and Qualification Rate
Priya is a first-time buyer under contract on a $525,000 townhome with a $420,000 7/1 ARM, 30-year amortization. The note rate is 6.250%, caps are 5/1/5, the margin is 2.750%, and the 30-day SOFR index at consummation is 4.300%. Her gross monthly income is $9,800. Monthly obligations are a $465 car payment, $160 in student loans, and a $100 credit card minimum; estimated property taxes and insurance are $1,100 per month. The automated underwriting finding is Approve/Eligible, and her realtor has told her not to worry because "you'll refinance or sell long before it adjusts." Priya asks you to quote her payment using the 6.250% start rate so she can compare it to rent, and she wants to know the worst case if she is still in the house in year eight.
1. Calculate her initial principal and interest payment, the worst-case payment at the first adjustment, and explain how the caps interact.
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Initial payment. $420,000 at 6.250% over 360 months: the payment factor is about $6.157 per $1,000, so principal and interest is roughly $2,586. With $1,100 for taxes and insurance, the full housing payment is about $3,686.
Caps. The 5/1/5 structure means a 5-point initial adjustment cap, a 1-point periodic cap after that, and a 5-point lifetime cap measured from the start rate. Start rate 6.250% + 5.000% = 11.250%, which is both the first-adjustment ceiling and the lifetime ceiling. Because the two caps coincide, the first adjustment can move the rate all the way to 11.250% in one step.
Worst case. $420,000 at 11.250% has a factor near $9.713 per $1,000, or roughly $4,079 principal and interest. Total housing becomes about $5,179, an increase of roughly $1,493 per month, or about 58% payment shock. That ceiling is reached only if the index plus 2.750% margin equals or exceeds 11.250%, meaning the index would have to be about 8.500% or higher at the first adjustment. That is not a forecast, but it is the number she must be able to survive, and it is the number a prudent originator shows her in writing.
2. Using the fully indexed rate, does she qualify at a 43% debt-to-income ratio, and what are her realistic options?
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Qualification rate. For an adjustable-rate loan, the qualifying rate is generally the greater of the fully indexed rate or the initial note rate. Fully indexed here is 4.300% index + 2.750% margin = 7.050%, which is higher than 6.250%, so 7.050% is the rate to use.
Payment at 7.050%. The factor is about $6.687 per $1,000, so principal and interest is roughly $2,808. Add $1,100 taxes and insurance for $3,908 in housing, plus $725 in other debt, for total obligations of about $4,633.
DTI. $4,633 ÷ $9,800 = 47.3%. At 43%, her maximum total debt is $4,214; after the $725 in consumer debt she has $3,489 for housing, which leaves $2,389 for principal and interest. That supports a loan of roughly $357,000, about $63,000 less than the $420,000 she needs.
Options. Increase the down payment by roughly $63,000, add a qualifying co-borrower, pay off or pay down the car and student loans and re-run, choose a fixed-rate product with a lower payment, or document strong compensating factors and let the automated or manual underwriter decide whether a higher ratio is supportable. She does not qualify on the start rate alone, and the realtor's "you'll refinance" argument is not a compensating factor. Quote the payment at 7.050% and disclose both numbers.
3. What ARM-specific disclosures must Priya receive, and when?
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At application, or within three business days of receiving it, she must receive the CHARM booklet and the ARM program disclosure required by 12 C.F.R. § 1026.19(b), which explains the index, margin, caps, payment calculation, an example of how the payment can change, and the fact that the loan may be assumable or convertible. Because the index is SOFR, the disclosure must identify the specific index and its source. She should also receive the servicing, appraisal, and homeownership counseling notices that apply to her application.
When the loan is consummated, the note itself must state the initial rate, the index and margin, the caps, and the lookback and adjustment dates. Once the loan is in force, the servicer must send a notice of the first rate adjustment between 210 and 240 days before the payment changes at the first adjustment, and later notices 60 to 120 days before each subsequent change, with the new rate, payment, and how it was calculated.
The originator's job is to make sure Priya understands that the 6.250% figure is an introductory rate tied to a discounted start, not a prediction of the loan's cost, and that the qualification is being run at 7.050%.