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If after five years, the index on a loan has gone down, the fully indexed rate could actually decrease.
The one-year ARM: Fully Indexed Rate (based on the 1 year Constant Maturity Treasury Index [CMT] plus an assumed 2.
Borrowers who get adjustable-rate loans will need to qualify for the fully indexed rate.
For example, Freddie Mac (NYSE: FRE), the huge GSE [Government-Sponsored Enterprise] which helps support the mortgage market, recently announced that as of September 1, 2007 it would only buy mortgages which were qualified based on the fully indexed rate, not on the initial teaser rate.
For ARMs with initial periods of 5 years or less, Fannie Mae will require that borrowers be qualified at the greater of the note rate plus 2 percent or the fully indexed rate (index plus margin).
Cutts explains that borrowers with one-year ARMs would find their fully indexed rate to be higher than what they can obtain with today's fixed rates.
In particular, while yields on our adjustable rate assets will ultimately move in response to movements in short term rates, they will do so with a lag owing to reset frequencies that are often greater than monthly and owing to interim and lifetime securities maximum coupon reset rates that may preclude a security from achieving its fully indexed rate.
The guidance specifies that an institution's analysis of a borrower's repayment capacity should include an evaluation of the borrower's ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule.