Qualifying. It’s always harder than it looks, right? I’ve talked before about my erstwhile career as an Ironman triathlete and for those familiar with that sport, they’ll confirm that qualifying for the race in Kona is way harder than they make it look on TV. I suppose it’s the same with getting into certain colleges, but since I struggled to get out of high school, I’m going to let someone else blog about that…
No, today, we’re going to talk about qualifying for a mortgage and specifically we’re going to cover the payment that we lenders use behind the scenes whenever any time of ARM loan is selected. Common mortgage programs, such as a 5/1 ARM or 7/1 ARM, are known as “hybrids” and the payment the lender uses to determine your debt-to-income ratio (DTI) and your asset reserve requirement will often vary from your “note” rate, which is the rate on which your actual monthly payment will be based. So how does the borrower keep this straight and avoid trouble in the loan process?
Getting a Fix on Qualifying Payment
While most of what follows could get a bit complex, one aspect of qualifying payments is simple. If you are obtaining a fixed rate loan (30-year fixed or 15-year fixed), your lender will use the actual payment for your qualification parameters. And most borrowers still do choose a fixed rate loan. If you’re one of them, very little of what follows might apply to your qualification and since blog posts about mortgages are generally pretty boring, this might be a great place to stop.
But what if you’re opting for, say, a 10/1 ARM? This is (usually) a 30-year term, but only the first 10 years of the term have a fixed rate (hence the “10” in 10/1). After year ten, the loan will become an adjustable rate mortgage (ARM) and will have an annual adjustment (that’s the “1” in 10/1) for the remaining 20 years. Because the adjustable rate will be determined by combining a fixed margin with a variable index, it’s impossible to know at the time of loan origination where the rate will go during the last 20 years. Yes, the adjustments will be governed by caps, but still the lender must allow for a rate that could possibly be higher than the fixed, start rate. In these cases, the lender will specify how the loan originator should qualify the borrower.
When we have an ARM, as above, there are three common qualifying payment scenarios a lender will require, plus another for extra credit (no pun intended):
- Qualify at the note rate. From time to time, we’ll see this on the 7/1 and 10/1 ARM and it’s usually a great deal where you can find it. Often a borrower’s greatest qualifying power can be found with programs of this nature. As stated, we treat these ARMs like a fixed rate loan for qualifying purposes. Whatever your locked/note rate, that is your qualifying rate.
- Qualify at the higher of the note rate or the fully-indexed rate. Where lenders don’t use the note rate on a 7/1 or 10/1, we’ll often see this structure. Let’s say our index is the 1-Year LIBOR and that, on the day of lock, the index is 2.6%. The loan’s margin, for example, is 2.25%. To obtain the fully-indexed rate (FIR) we add the index and margin, so here we have 4.85%. If the borrower is locking at 7/1 ARM at 4.125%, under this profile he’d still need to qualify for the loan based on a rate of 4.85% as it’s the higher of the two. Further, his asset reserve requirement would need to be based on the payment at 4.85%.
- Qualify at the higher of the note rate + 2% or the fully-indexed rate. We see this a lot with the 5/1 ARM. Borrowers often think that because the note rate can be lowest on this program, it may afford them the greatest qualifying power. Unfortunately, they have to think again. Lenders artificially increase the qualifying payment on shorter-term ARMs to offset risk of the fewer amount of fixed years and this frequently conspires to make the 3/1 ARM and 5/1 ARM harder to qualify for than their brethren of 7 or 10 years.
- Interest-only? All bets are off… OK, not really. But as an extension of the logic on the 3/1 and 5/1 ARM qualification, lenders in the age of the Qualified Mortgage (QM) have to qualify interest-only loans to a much higher standard of the borrower’s expected ability to repay. For this reason, interest-only loans typically have the highest qualifying payments of all programs. Usually, if you have a 10/1 interest-only loan, the lender might be required to use the higher of the note rate or fully-indexed rate, amortized over the period of time that is not fixed (in this case, 20 years). And as we know, shorter amortization periods mean higher payments, all other things equal.
So there you have it. Punching your ticket to the big dance, whether it’s the college of your dreams, the toughest day in endurance sports or your next home purchase, might involve some qualifying gymnastics. If you could use a good coach, give me a call any time.
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