In ARM underwriting, the borrower's ability to repay is calculated at which rate?

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In ARM underwriting, the borrower's ability to repay is evaluated using the fully indexed rate. This rate is the current index plus the loan’s margin and represents the actual rate that could apply after adjustments over time. Using the fully indexed rate to compute the payment ensures you’re testing affordability under the rate that could reasonably occur, not just the initial teaser payment.

Why this matters: teaser or initial rates are often lower for a period, which can make the early payments look affordable even though they will rise. The note rate is the contract rate at closing, but it may not reflect future costs once the loan adjusts. The cap rate limits how high the rate can go, but it doesn’t determine the ongoing payment level to test for repayment. The fully indexed rate captures the highest plausible payment scenario an ARM borrower could face, making it the appropriate basis for evaluating ability to repay.