5/1 ARM Qualification When the Teaser Payment Looks Affordable
A borrower is considering a $400,000 5/1 ARM to buy a condo. The note has an initial rate of 5.25% for the first 60 months, a margin of 2.75%, a periodic adjustment cap of 2 percentage points, a lifetime cap of 5 percentage points above the initial rate, and a floor equal to the margin. The index is SOFR, which is 4.30% at consummation. The loan is interest-only for the first 5 years; principal-and-interest payments begin at the first adjustment. The borrower's gross monthly income is $11,000; other debts are a $650 car payment and a $300 student loan. The lender's qualification policy requires using the greater of the fully indexed rate or the initial rate plus 2%, and qualifying on the fully amortizing payment at the first adjustment. The borrower wants to know whether the lower initial payment means she can afford more house, and what happens at the first adjustment if SOFR rises to 6.00%.
1. Calculate the fully indexed rate, the initial adjustment cap, the lifetime cap, and the rate the lender should use to qualify this borrower.
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The fully indexed rate is the index plus margin: 4.30% + 2.75% = 7.05%. The initial rate plus 2% is 5.25% + 2.00% = 7.25%. The lender must use the greater of those two, so the qualification rate is 7.25%. The first-adjustment cap limits the rate at the 60th month to 7.25%, even if the fully indexed rate would be higher. The lifetime cap is 5 percentage points above the initial rate: 5.25% + 5.00% = 10.25%. The floor is the margin, 2.75%. The loan must be qualified using the fully amortizing payment at 7.25%, not the interest-only payment at 5.25%. Using the teaser payment would understate the borrower's obligation and could mask payment shock.
2. Using the qualification rate, estimate the monthly principal-and-interest payment and the borrower's DTI including the listed debts. What does this show about the teaser payment?
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At 7.25% on a $400,000 30-year amortizing loan, the monthly principal-and-interest payment is approximately $2,728. The interest-only payment at 5.25% is $400,000 × 5.25% ÷ 12 = $1,750. The payment shock at the first adjustment is therefore about $978 per month before taxes and insurance. Including the $650 car payment and $300 student loan, total monthly obligations are about $2,728 + $650 + $300 = $3,678. On $11,000 gross monthly income, the DTI is about 33.4%. That is within many conventional limits, but the result depends on taxes, insurance, HOA dues, and any other debts. The key point is that the borrower should not qualify on the $1,750 interest-only payment; the lender's policy correctly uses the fully amortizing payment at the higher of the fully indexed rate or initial rate plus 2%.
3. If SOFR is 6.00% at the first adjustment, what rate and payment apply, and what should the loan originator explain to the borrower?
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At 6.00% SOFR, the fully indexed rate would be 6.00% + 2.75% = 8.75%. However, the first-adjustment cap limits the rate to 7.25%-the initial rate plus 2 percentage points. So the first adjusted payment is based on 7.25%, approximately $2,728, not on 8.75%. At later adjustments, the rate could rise by another 2 percentage points to 9.25%, and eventually to the 10.25% lifetime cap, subject to the index and floor. The loan originator should explain that the initial interest-only payment is temporary, that the first adjustment is capped but still produces payment shock, and that the borrower's ability to afford the loan should be judged on the fully amortizing payment including taxes, insurance, and HOA dues. The borrower should not assume the teaser payment is permanent or that the first cap eliminates risk.