Freddie Mac Guidelines: ARM Qualification Requirements

Why ARM Qualification Rules Exist

Adjustable-rate mortgages start with attractive low rates, but those rates will increase over time. Fannie Mae requires lenders to qualify borrowers at higher rates to prevent payment shock when the rate adjusts upward.

Think of it this way: if you qualify for a 5/6-month ARM at a 4% start rate, but the rate could jump to 6% after five years, the lender needs to know you can afford the higher payment. This protects both you and the investor who buys your loan.

The qualification requirements vary by ARM type because different products carry different levels of risk. Short-term ARMs like 3/6-month products adjust more frequently, so they require more conservative qualification standards.

How Qualification Rates Work by ARM Type

3/6-Month ARMs

These loans adjust every six months after an initial three-month fixed period. You must qualify at the note rate plus the full 5% life cap.

Say you're getting a 3/6-month ARM with a 3.5% start rate and a 5% life cap. The lender must qualify you at 8.5% (3.5% + 5%). This ensures you can handle the maximum possible payment if rates rise to their ceiling.

5/6-Month ARMs

These loans stay fixed for five years, then adjust every six months. You must qualify at whichever is higher: the note rate plus 2 percentage points, or the fully indexed rate.

Here's an example: Your 5/6-month ARM has a 4% start rate. The current index is 3% and the margin is 2.5%, making the fully indexed rate 5.5%. You'd qualify at 6% (the note rate of 4% plus 2 percentage points) since that's higher than the 5.5% fully indexed rate.

7/6-Month and 10/6-Month ARMs

The qualification requirements depend on whether your loan is classified as a Higher-Priced Covered Transaction (HPCT) or Higher-Priced Mortgage Loan (HPML).

For standard loans that aren't high-priced, you qualify at the note rate. For high-priced loans, you must qualify at whichever is higher: the note rate or the fully indexed rate.

Understanding the Fully Indexed Rate

The fully indexed rate equals the current index value plus your loan's margin, rounded to the nearest one-eighth percent (0.125%). Lenders can use any index value from the 90 days before your note date.

Your loan documents will specify both the index (like SOFR) and the margin. If SOFR is currently 2.75% and your margin is 2.25%, your fully indexed rate would be 5% (2.75% + 2.25% = 5%, which rounds to the nearest eighth).

This rate represents what your payment would be if the loan adjusted today, without considering any caps or floors.

Special Rate Restrictions

Fannie Mae limits how low the initial rate can go on certain ARMs. For 3/6-month and 5/6-month ARMs, the start rate cannot be more than three percentage points below the fully indexed rate.

This prevents lenders from offering artificially low teaser rates that would create severe payment shock. If the fully indexed rate is 6%, the lowest possible start rate would be 3%.

Required Documentation

Lenders must document the qualification rate calculation in your loan file. This includes:

• Current index value and source
• Loan margin from your note
• Calculation showing the fully indexed rate
• Comparison of qualification rate options
• Payment calculation at the qualification rate

Your loan officer should provide a clear breakdown showing which rate they used for qualification and why. This documentation helps the underwriter verify compliance with Fannie Mae requirements.

ARM Buydown Complications

If your ARM includes a buydown (either temporary or permanent), additional rules apply. You must still meet the standard ARM qualification requirements outlined above, even with the buydown in place.

Temporary buydowns reduce your payment for a specific period, but the lender still qualifies you at the higher ARM qualification rate. This ensures you can afford the payment when both the buydown expires and the ARM adjusts.

Note that 3/6-month ARMs cannot be combined with any type of buydown program. This restriction exists because these loans already carry higher risk due to their frequent adjustment schedule.

Common Qualification Pitfalls

Many borrowers underestimate how much the qualification rate affects their buying power. A 5/6-month ARM with a 4% start rate might seem affordable, but qualifying at 6% significantly reduces your maximum loan amount.

Some borrowers also assume they can refinance before the rate adjusts. While this strategy sometimes works, you should qualify based on your ability to handle the higher payment, not on refinancing assumptions.

High-priced loan classifications can surprise borrowers. If your loan falls into HPCT or HPML categories, you'll face stricter qualification requirements that might affect your approval.

Rate Calculation Timing

Lenders have flexibility in choosing the index value for fully indexed rate calculations. They can use any value from the 90 days before your note date, which means the calculation might change between application and closing.

This timing flexibility helps lenders manage rate volatility, but it can create uncertainty for borrowers. Your qualification rate could increase if index rates rise between application and closing.

The rounding requirement (to the nearest one-eighth percent) can also affect your qualification rate. A fully indexed rate of 5.94% rounds to 6%, while 5.93% rounds to 5.875%.

References

For the official guidelines, see 4401.2: Underwriting requirements for ARMs in the Fannie Mae Selling Guide.