Freddie Mac released its 22nd annual Adjustable Rate Mortgage (ARM)
Survey last week. The study found that traditional 1-year ARMs have lost even
more market share to hybrid ARMs and that lenders have continued,
even increased, initial period discounts to borrowers to keep ARMs viable in
the mortgage marketplace despite a flattening yield curve.
Perhaps a brief jargon translation is appropriate here, interspersed with a
discussion of Freddie Mac's survey results.
The 1-year ARM is a mortgage in which the rate is set for one year and then
adjusts every year thereafter, not willy-nilly, but with standards and restrictions
based on indexes and margins. A hybrid ARM is one with a longer term introductory
period - three, five, seven, even ten years during which the rate remains
at its original level and then adjusts every year thereafter. Borrowers, particularly
those who will be stretching to make payments often choose an ARM because the
lower payments for the first year or first five years allow them to qualify
for a mortgage.
But at present the yield curve is flat. The yield curve is the difference between
the return on short term and long term interest rates. At present, economic
manipulations such as the many mostly one-quarter percent adjustments the Federal
Reserve has made to the Federal Funds Rate over the last months are not, for
whatever reason, being reflected by or reacted to by longer term rates. The
result is a decreasing difference between long term rates, say ten or 30 years,
and those available to borrowers taking loans for 30, 90, or 365 days. As the
difference between long term and short term rates lessen, it is said that the
yield curve "flattens."
Economists state that a flattening yield curve has ramifications
for the entire economy. Of most concern is the history of, what happens when
the two indicators have inverted, i.e., long term rates have dropped below short
term rates. Without exception since 1969 this has signaled that the financial
markets expect a downturn, which would force the Fed to cut rates. Such an inversion
has, with a few exceptions, been followed by a recession.
According to the Freddie Mac report, the flattening of the yield curve was
clearly evident in the Treasury market over the course of 2005: The rate spread
between 10-year and 1-year constant-maturity T-bill yields was 1.5 percentage
points at the start of the year, yet ended the year close to zero. During periods
of a flat yield curve, the initial interest savings on ARMs becomes small relative
to fixed-rate mortgages. As a result, ARMs are less attractive to borrowers.
So, if a homebuyer or homeowner is given the choice between borrowing at 7 percent
for a year with the possibility the rate could adjust upwards as much as two
or three points at the end of that period or taking a loan at 7.35 percent with
the rate locked down for a ten or a 30 year period, the choice should be obvious.
The benefits of the fixed rate may, however, be mitigated by the initial loan
payment which the borrower might not be able to manage at the higher fixed rate.
Such borrowers were either forced out of the market or forced to scale back
their home-buying or refinancing plans.
No business wants to lose a customer, so to keep adjustable rate mortgages
affordable, lenders discount the initial term to keep a reasonable difference
between ARMs, particularly the short term ones, and fixed rate mortgages.
"In the last half of 2000, the last time the Treasury yield curve inverted,
the one-year conforming, conventional ARM rate had a discount of about 1.6 percentage
points," according to Freddie Mac economist Michael Schoenbeck.. "Yet
the ARM share of conventional originations was in the 15 to 20 percent range,
well below the shares for much of 2004 and 2005."
Yet, through this past November, ARMs accounted for about 32 percent of loan
applications in 2005, according to Freddie Mac's weekly Primary Mortgage Market
Survey. Since 1995, the first year that Freddie Mac collected ARM share data,
the ARM share has fluctuated between an annual low of 11 percent in 1998 and
a high of 33 percent in 2004.
Compared with the 2004 ARM survey, savings on ARMs are now smaller, even with
the initial rate discounts from lenders. For example, the one-year adjustable
carried a rate that was 1.6 percentage points below a 30-year fixed-rate loan
in the last survey, but only 0.9 percentage points lower in the current survey,
reflecting the rise in short-term interest rates over the last several months.
Over the last several years, annually adjusting ARMs with an initial "fixed-rate"
period of more than one year, known as "hybrid" ARMs, have grown in
popularity. Within that product type, ARMs with an initial fixed-rate period
of five years, known as "5/1" ARMs, have been the dominant choice
of consumers. According to Freddie Mac Chief Economist Frank Nothaft, "In
2005, two-in-five ARMs were 5/1 hybrids."
The Freddie survey, based on responses from 106 ARM lenders
during the period of December 19 to December 22, found that starting rates for
ARMS would have increased even further where it not for greater initial rate
discounts which had the effect of, at least temporarily "unflattening" the yield
curve. Lenders during this period, in fact through most of the year, were typically
offering a lower initial interest rate than what the fully adjusted rate would
be at the time of origination. For example, a 1-year ARM with an underlying
index rate of 4.37 percent and a margin (the premium added to the index rate)
of 2.77 percent would have a "fully indexed rate" of 7.14 percent. Lenders are,
in this example, discounting the rate by 1.92 percent, bringing the initial
interest rate to 5.22 percent. These discounts drop as the initial loan period
(three, five, or ten years) increase. In our example, given a 4.37 index and
2.77 margin, the discount of 1.92 percent for a one year loan would decrease
to 1.04 for a 10/1 hybrid, resulting in an initial interest rate for the latter
of 6.10 percent. Using Freddie Mac's Primary Mortgage Market Survey for the
week ending December 22, 2005, the interest rate on conventional, conforming,
30-year FRM was 6.26 percent with average fees and points of 0.6 percentage
points, or an "effective" rate of 6.39 percent.
The 5/1 ARM, with a lenders discount of 1.34 percent and an initial rate of
5.80 percent probably struck the most favorable balance between affordability
and safety (for five years at least) for those who were either unable to afford
payments on a 30 year fixed or did not plan to hold on to their house or their
mortgage for more than five years.
In last year's survey, the discount on 1-year ARMS averaged 1.4 percentage
points (conventional and Treasury indexed). This year it had increased by a
half percentage point to an average of 1.9 points. The average over the last
22 years has been 1.7 percent.
The survey found that 5/1 hybrid was available at four-out-of-five
lenders that offered an ARM product, but only 56 percent of the lenders that
offered ARMs offer the traditional one-year ARM - the lowest share in the 22-year
history of the survey.
Potential homebuyers and existing homeowners opting for a Treasury-indexed ARM
amortized over 30 years with a loan amount of about $200,000 can expect initial
savings (up until the first rate adjustment) over a fixed-rate mortgage of up
- About $1,630 for one-year conforming ARMs;
- Almost $990 for 3/1 ARMs;
- About $1,110 for 3/3 ARMs (wherein the mortgage rate adjusts every three
- Nearly $760 for 5/1 ARMs;
- Around $510 for a 7/1 ARM.