Two Offers, One Income, and a Merger Announcement
Marcus and Elena are buying a $520,000 townhouse with 20% down, a 760 middle score, and $58,000 in verified reserves. Marcus earns $8,400 gross monthly; Elena, a nurse, earns $2,800. Their monthly obligations are an auto loan at $520, a student loan at $240 (the servicer's statement shows an income-driven payment of $240, not $0), and credit card minimums of $95. Property taxes are $650, insurance $140, and the HOA dues $210. On the $416,000 loan the originator offers a 30-year fixed at 6.500% or a 5/1 ARM at 6.125% with 2/2/5 caps, a 2.750% margin, and a current index of 4.300%. The borrowers expect to move in five to seven years and want the lower payment. Elena's hospital has just announced a merger, and she asks whether the ARM's smaller payment 'keeps us safe if one income disappears.'
1. At what interest rate must this file be qualified, and what is the resulting debt-to-income ratio? Show the calculation.
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The note rate is not the qualifying rate on an adjustable-rate loan. Underwrite at the greater of the fully indexed rate or the note rate. Fully indexed equals index plus margin: 4.300% + 2.750% = 7.050%, which exceeds the 6.125% start rate, so 7.050% governs. (If the loan were a higher-priced covered transaction, you would instead use the maximum rate permitted during the first five years, which here would be 6.125% + 2% = 8.125%.)
Payment at 7.050% on $416,000 over 360 months: the monthly factor is about 0.0066856, giving roughly $2,781 of principal and interest. Add taxes $650, insurance $140, and HOA $210 for $3,781 of housing expense. Add the $520 auto, $240 student, and $95 card minimum for $855 of other debt. Total obligations are $4,636 against $11,200 of gross monthly income.
Debt-to-income is 4,636 / 11,200 = 41.4%. That is inside automated underwriting limits but no longer comfortable, and it leaves little room for the HOA to rise or for a car payment to appear. The student loan figure is acceptable because the documented income-driven payment is $240, not $0; a $0 payment would require counting 1% of the balance.
2. What are the worst-case rates and payments on the ARM, and how large is the payment shock?
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Apply the caps in order. The first adjustment is limited to 2 percentage points, so the highest rate at month 61 is 6.125% + 2.000% = 8.125%. Every later adjustment is capped at 2 points, and the lifetime cap is 5 points over the start rate, so the maximum ever is 6.125% + 5.000% = 11.125%. Note that the lifetime ceiling, not the periodic caps, controls the long-run worst case.
Payments on $416,000: at 8.125% the factor is about 0.0074252, or roughly $3,089 per month; at 11.125% the factor is about 0.009617, or roughly $4,001 per month.
The relevant shock is not measured from the qualifying payment but from what the borrowers will actually feel. Their start payment at 6.125% is about $2,527. A first adjustment to the cap raises it to $3,089, an increase of $562, or 22.2%. Housing expense then becomes $3,089 + $1,000 = $4,089, and total obligations $4,944, pushing debt-to-income to about 44.1%. If the index moved only modestly, the payment could still rise by the full margin-adjusted amount, so the borrower should be shown the capped number, not the expected one.
3. The borrowers ask which product is smarter given a five-to-seven-year horizon, and whether the ARM protects them if one income disappears. Advise them with numbers.
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Start with the arithmetic. The fixed payment at 6.500% is about $2,629; the ARM start payment is about $2,527, a saving of roughly $102 per month, or about $6,120 over 60 months. If at month 61 the rate resets to the cap of 8.125%, the payment becomes about $3,089 - $460 more per month than the fixed payment would have been. The accumulated saving is erased in roughly thirteen months. So the ARM wins only if the borrowers actually sell or refinance before the first adjustment, and they should be told that a refinance is not guaranteed because their income, the value, or rates may have moved.
On the merger question, be direct: the ARM does not protect against income loss. Every dollar of the lower payment still depends on both incomes, and a 41.4% qualifying ratio computed on two incomes leaves no capacity to carry the loan alone. If income loss is a genuine concern, the fixed product at $2,629 is the more defensible choice, and the conversation should shift to reserves, a smaller purchase price, or an escrowed buydown rather than to a lower start rate.