The 3/1 ARM and the First Adjustment
Mr. Okafor is considering a 3/1 ARM for $380,000 over 30 years. The initial rate is 5.25%. The margin is 2.75%, and the index, a SOFR-based rate, is 4.20% at origination. The initial adjustment cap is 2%, the periodic cap is 2%, and the lifetime cap is 5% over the initial rate. The floor equals the margin. Mr. Okafor plans to sell in about seven years. At the first adjustment, the index is 7.10%. His current housing payment, including taxes and insurance, is $2,050, and he has asked whether the loan is "safe" because the start rate is lower than the fixed option he was quoted.
1. What is the fully indexed rate at origination, and why does it differ from the note rate?
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The fully indexed rate is the margin plus the index: 2.75% + 4.20% = 6.95%.
The note rate of 5.25% is a discounted introductory rate, about 1.70 percentage points below the fully indexed rate. That discount is the reason the start rate looks attractive compared with the fixed option. The loan is not priced at 5.25% for its life; it is priced at the index plus 2.75%, subject to caps.
The floor matters here. Because the floor equals the margin, the rate can never fall below 2.75% even if the index drops to zero. A borrower who hears "the rate can go down" should understand that the floor limits how far.
For Mr. Okafor, the practical lesson is that 6.95% is the neutral starting point for comparing this ARM with a fixed loan. Comparing the 5.25% start rate to a fixed rate overstates the ARM's advantage, because the discount disappears at the first adjustment.
2. What is the rate at the first adjustment if the index is 7.10%? Show the cap analysis.
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The uncapped fully indexed rate would be 2.75% + 7.10% = 9.85%. The caps prevent the rate from reaching that level.
The initial adjustment cap limits the first change to 2 percentage points above the initial rate: 5.25% + 2.00% = 7.25%. The periodic cap also limits the change to 2 points, which produces the same ceiling. The lifetime cap is 5 points over the initial rate, or 10.25%.
Comparing the three limits: 9.85% (uncapped), 7.25% (initial and periodic cap), and 10.25% (lifetime cap). The lowest ceiling controls, so the new rate is 7.25%.
That is still a 2-point jump at the first adjustment. At the next adjustment, the rate could rise another 2 points to 9.25%, and later to the 10.25% lifetime maximum, depending on the index. Mr. Okafor should see this schedule in writing, not just hear the 5.25% start rate.
3. Calculate the payment change and explain how the loan should be qualified under ability-to-repay rules.
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Principal and interest at 5.25% on $380,000 over 360 months is approximately $2,098. At 7.25%, it is approximately $2,592. The increase is about $494 per month, or roughly 23.5%.
For ability-to-repay purposes, the qualifying rate is the maximum rate that can apply during the first five years. Because the first adjustment occurs at month 37, the maximum in that window is the initial rate plus the initial cap: 5.25% + 2.00% = 7.25%. The debt-to-income ratio must be calculated using the $2,592 payment, plus taxes, insurance, HOA dues, and any subordinate-lien payments. Qualifying at $2,098 would understate the borrower's obligation.
Mr. Okafor's seven-year horizon is a warning, not comfort. He faces a second adjustment at month 61, while he still owns the home. At 9.25%, principal and interest would be roughly $3,126, which is more than $1,000 above the start payment. The loan may be appropriate for him, but only if he can absorb that range and understands that selling in year seven depends on home values and market conditions, not on the loan's terms.