Do I Need an Adjustable Rate Mortgage to Qualify?

August 3, 1998, Revised November 16, 2006, Reviewed February 12, 2011

"I have been told by my loan officer that I can qualify for the loan I need only with an adjustable rate mortgage (ARM). I much prefer a fixed-rate mortgage (FRM). Is there any appeal"?

Yes, but you have to shift into active mode and not allow the loan officer to lead you around by the nose.

Why It is Easier to Qualify With an ARM

It is easier to qualify with an ARM than with an FRM because the initial interest rate, and therefore the initial monthly mortgage payment, is usually lower on an ARM. In deciding whether you have enough income to meet your monthly payment obligation, lenders usually use the initial interest rate on an ARM to calculate the payment, even though the rate usually rises at the end of the initial rate period.

If you qualify with an ARM but not an FRM, it means that with the FRM you exceed the maximum allowable ratio of your housing expense to your income, or your total expense to your income. Housing expense is the sum of the mortgage payment including mortgage insurance, hazard insurance and property taxes, while total expense is housing expense plus monthly payments to service your existing debt. Typical maximum ratios are 28% and 36%, respectively.

What is less well understood is that many borrowers who are told that they require an ARM to qualify in fact could have qualified with an FRM. It just takes a little more work on the part of the loan officer.

Maximum Expense Ratios Are Not Rigid

Maximum expense ratios actually vary somewhat from one loan program to another. Hence, if you are only marginally over the limit, nothing more may be required than to find another program with higher maximum ratios. This is a situation where it is handy to be dealing with a mortgage broker who has access to loan programs of many lenders.

Maximum expense ratios, furthermore, are "guidelines", not absolute limits. The following are some circumstances where the limits may be raised.

* The borrower is just marginally over the housing expense ratio but well below the total expense ratio – 29% and 30% for example, when the maximums are 28% and 36%.

* The borrower has a high credit score.

* The borrower is a first-time home buyer who has been paying rent equal to 36% or more of income without any problems.

* The borrower is making a large down payment.

Techniques For Reducing Ratios

If it is not possible to raise the maximum acceptable ratios in any of these ways, it may be possible to reduce your ratios -- provided you have planned to make a down payment larger than the absolute minimum. You can use the cash that would otherwise have gone to the down payment to reduce your expense ratios by paying off debt, paying points to reduce the interest rate, or funding a temporary buydown.

The first two approaches will work only in a small percentage of cases, however. For example, paying an extra 2.625 points to reduce the rate from 7% to 6.375% will reduce your housing expense ratio by about 1 percentage point. This assumes, furthermore, that the reduced down payment does not push you into a higher mortgage insurance premium category, which would offset most of the benefit.

Using the extra cash to pay off debt will work only if a) you exceed the maximum total expense ratio but not the maximum housing expense ratio (your ratios are 27% and 38%, for example, when the maximums are 28% and 36%); and b) your existing debts have short terms and high rates. For example, if you increase your loan by 2.6% and use the increase to repay debt, and if the debt has an average rate of 15% and is being repaid over 5 years, you would reduce your total expense ratio by about 2 1/2 percentage points.

Much the most effective way to reduce both expense ratios is to use a temporary buydown. Assuming a market interest rate of 7% on a 30-year FRM, an increase in the loan amount of 2.5% will fund a 2-1 buydown, where the payment is calculated in year one at 5% and in year 2 at 6%. This would reduce your expense ratio in year one by about 4 1/2 percentage points. Read What Is a Temporary Buydown?

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