The mortgage reform legislation sets minimum standards for lenders. The most basic new standard prevents a creditor from offering a residential mortgage to a borrower without "a reasonable and good faith determination ... that ... the consumer has a reasonable ability to repay the loan."
Ability to repay is a straightforward calculation for fixed-rate loans. For adjustable-rate mortgages, the lender must ignore the introductory (or "teaser") mortgage rate when determining whether a borrower can afford the loan.
Instead, the lender has to calculate what the payments would be if the borrower got a fixed-rate loan at the ARM's fully indexed rate.
Take the example of a borrower getting a 5/1 ARM with a fully indexed rate of 2.25 percent above the one-year Libor. At closing, the one-year Libor rate is 3 percent. Add them together for a fully indexed rate of 5.25 percent.
The lender will determine whether the borrower can afford the payments on a 30-year, fixed-rate mortgage at 5.25 percent -- even though the borrower initially will pay less, and eventually might pay more (if rates rise later).
The legislation says the lender has to verify income, preferably with tax transcripts obtained from the Internal Revenue Service.