Fixed, ARM, or Buy the Rate Down
Marcus is buying a $500,000 home with 20% down, a $400,000 first mortgage, 740 FICO. Option A is a 30-year fixed at 6.875%; 1 discount point ($4,000) buys the rate down to 6.50%. Option B is a 7/1 ARM at 6.125% with 2/2/5 caps, a 2.75% margin, and an index currently at 5.00%. Option C is the same 7/1 ARM with no point. Marcus expects a transfer in about four years and does not intend to stay in the house after that. His middle FICO is 740 and he will have $40,000 left in savings after closing. Property taxes and insurance total $650/month on every option.
1. At what interest rate must Marcus be qualified on the 7/1 ARM, and why?
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Qualify at 7.75%, not 6.125%.
- The fully indexed rate is index + margin = 5.00% + 2.75% = 7.75%.
- The Ability-to-Repay rule (12 CFR 1026.43(c)(5)(i)) requires underwriting using the greater of the fully indexed rate or any introductory rate, and considering the maximum rate that could apply during the first five years. On a 7/1 ARM the note rate cannot adjust during the first five years, so 6.125% never becomes the qualifying rate on its own; 7.75% controls.
- Principal-and-interest on $400,000 over 30 years: about $2,866 at 7.75% versus about $2,430 at 6.125%. That $436/month gap is what the borrower must be able to carry, and it is what the DTI is calculated on.
- For comparison, the fixed option at 6.875% qualifies at roughly $2,628 P&I. Note that the ARM's qualifying payment is higher than the fixed loan's qualifying payment even though the ARM's start payment is much lower. That is the whole point of the rule and the thing most borrowers do not understand.
2. Compute the breakeven on the 1-point buydown on the fixed loan.
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- Rate reduction: 6.875% to 6.50%.
- P&I at 6.875% on $400,000/30 years = about $2,628.
- P&I at 6.50% = about $2,528.
- Monthly saving = $100; annual saving = $1,200.
- Cost of the point = $4,000.
- Breakeven = $4,000 / $1,200 = 3.33 years (about 40 months).
Interpretation: with a four-year expected holding period the point has a thin margin - roughly eight months of benefit before the transfer, and only if the loan actually runs that long. If Marcus sells, refinances, or pays off early, the unamortized portion of the point is stranded. The breakeven is also rate-sensitive: if he is at all likely to be there three years rather than four, the point is a loser. A buydown should be priced against the borrower's actual expected holding period, not against the loan term.
3. Which option fits a four-year horizon, and what risks must you explain before he chooses?
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Recommendation: the no-point 7/1 ARM (Option C) is the best fit, with clear disclosure of the downside.
Why:
- The rate is fixed for seven years, longer than his four-year horizon, so the payment risk he actually faces is zero during the hold period - the cap structure does not bite until year 8.
- Payment comparison: about $2,430 P&I on the ARM versus $2,528 on the fixed with the point and $2,628 without it. Over four years the ARM saves roughly $9,500 against the un-bought-down fixed, with $4,000 more cash left in reserve.
Risks to explain in writing:
- Cap structure 2/2/5. First adjustment (year 8) caps at 8.125%; then 10.125%; lifetime ceiling 11.125%. At 8.125% his payment is about $2,970 P&I - he must be told that number even if he plans to leave.
- The index is at 5.00% today, so the fully indexed rate is already 7.75%. If he keeps the loan, the first adjustment is likely upward, not lateral.
- Housing-turnover risk. If the transfer slips or the market softens and he cannot sell, he is in an adjustable loan in year 8 with a payment he may not like.
- No negative amortization, no prepayment penalty - confirm both from the note and say so.
- The four-year plan must be documented: what he does at year 4 is his business, but the recommendation should be tied to a stated intent, and the file should show he was offered the fixed and the buydown economics.