Freddie Mac 23rd Annual Adjustable Rate Mortgage (ARM) Survey released last week contained few surprises. The three major findings were:

• A decline in the market share of ARMs as savings from these loans as compared to fixed rate loans shrank;
• Greater lender discounts to entice borrowers into taking out ARMs;
• The increasing popularity of hybrid ARMS relative to one-year adjustables.

The survey was based on data collected over a three day period in December. Commenting on the results Frank Nothaft, Freddie Mac vice president and Chief Economist said "The Federal Reserve increased short-term interest rates during the first half of 2006, raising the federal funds target from 4.25 percent to 5.25 percent. This contributed to a rise in short-term interest rates relative to long term rates. This phenomenon is reflected in mortgage pricing as well as with products that re-price more frequently showing the largest increase in interest rates." As an example he pointed out that first-year rates on one-year ARMS rose about 0.3 percentage points over the year while the 5-year hybrid increased 0.2 percent and the long term ARM (10/1) and 30 year rates were virtually unchanged from the same time period a year earlier.

The starting rates for ARMs would have increased even further but for greater use of initial-rate discounts by lenders which are lower than the fully adjusted rate would be at the inception date based on the underlying index rate plus the margin. At the end of 2005 the average discount was 1.9 percent for the one-year ARM but by December 2006 this had increased to 2.3 percentage points, the highest discount since 1997. Over the history of the ARM survey the discount on these one-year ARMs have averaged 1.7 percentage points.

Nothaft observed that as the difference between the 30-year fixed rate mortgage and the fully indexed ARM rate decreases lenders generally offer a larger initial discount on the latter which helps lenders to maintain ARM originations.

For example, during the week ended December 21, 2006, the underlying index rates for 1-year, 5/1, 7/1, and 10/1 loans was 4.95 percent. The margin was within two basis points plus or minus of 2.77 leading to a fully-indexed rate ranging from 7.73 to 7.75 percent. The discount offered to borrowers was 2.29 percent for the 1/1, 1.84 for the 3/1 hybrid, 1.76 for the 5/1, and 1.60 for the 10/1.

Applications for ARMs accounted for 25 percent of all loan applications in November 2006. Over the 23 years of the survey the market share of ARMs has fluctuated between 11 percent in 1998 and 33 percent in 2004. "Consumers are financially savvy and respond to changes in the relative cost of different loan products," Nothaft said. "As ARMS became more expensive relative to fixed-rate loans during 2006, the ARM share of lending declined."

The 5/1 hybrid ARM in which the initial interest rate remains constant for five years before adjusting and then adjusts every year thereafter continues to be one of the most popular ARMs. In 2006 40 percent of ARMs were 5/1 hybrids. As recently as 1999 40 percent were the traditional 1-year adjustable.

Freddie Mac will also issue its monthly economic and housing forecast this week.