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ARMs Gain in Popularity, Despite Lower Benefit

5/1 hybrid most popular, Freddie survey says

January 6, 2005

By MortgageDaily.com staff

Despite a smaller spread between adjustable rates and fixed rates, ARM share remains strong. And among hybrid ARMs, the 5/1 is the most popular and presents borrowers with the biggest initial savings over a fixed rate mortgage.

Freddie Mac announced those were some of the findings in its 21st Annual Adjustable-Rate Mortgage Survey.

Freddie found that even with bigger initial rate discounts on ARMs, the spread between ARMs and fixed-rate mortgages was lower this year. "For example, the one-year adjustable carried a rate that was 2.0 percentage points below a 30-year fixed-rate loan in the last survey, but only 1.6 percentage points lower in the current survey, reflecting the rise in short-term interest rates over the last several months," it said.

The Federal Reserve hiked up short-term interest rates five times over the last half of 2004, according to the announcement, raising the Federal Funds target from 1.0% to 2.25%. While long-term mortgage rates averaged about the same at the end of 2004 as they did at the start, initial rates on ARMs rose about 40 basis points over the course of the year as they typically are priced off of shorter maturity financial instruments that match the length of the initial adjustment period.

"ARMs would have increased even further were it not for greater use of initial-rate discounts by lenders," who encourage consumers to opt for an ARM by offering a lower initial interest rate than what the fully-adjusted rate would be at the time of origination, Freddie said. Conventional, conforming 1-year Treasury-indexed ARMs began the year with initial-rate discounts amounting to nearly 0.38% -- but ended the year with an average discount of 1.34%. Initial one-year discounts over the past 21 years reportedly averaged about 1.7%.

"When the interest-rate difference between a 30-year fixed-rate mortgage and the fully-indexed ARM rate decreases, lenders generally offer a larger initial rate discount on the ARM," Freddie's chief economist Frank Nothaft said in the announcement. "The larger initial discounts increase the initial rate benefit of an ARM compared with fixed-rate loans, helping lenders to maintain ARM originations."

The year reportedly started with a steep Treasury-yield curve -- the spread between the 10-year and 1-year constant-maturity yields was 2.91% -- but ended narrower, with the spread settling at 1.57%.

ARMs become more popular during steep yield curve periods, Freddie said, as was the case midyear when the ARM share peaked in June at 40% of total conventional purchase originations, following the year's high of 2.94% in the 10-year and 1-year Treasury rate spread in May.

Through November, ARMs accounted for 34% of conventional purchase originations -- marking the highest annual share since 1994's level of 39%. The highest annual ARM share occurred in 1984 at 62%, Freddie said.

Within the ARM product market, the dominant product was the 5/1 hybrid ARM, which has an initial "fixed-rate" period of five years and adjust annually thereafter. In 2004, two-of-five ARMs, and three-of-five hybrids, were 5/1 ARMs. The average initial interest rate on 5/1 hybrids was 4.99%, which was 0.65% below the rate on a 30-year fixed-rate mortgage -- and 0.82% above the rate on the traditional 1-year. "Hybrid ARMs provide the consumer the comfort of knowing that the interest rate will be fixed over the first five years of the loan. However, the interest rate may jump as much as five percentage points on the fifth anniversary. Thus, the product has been popular with families who plan to have the mortgage for five years or less," Nothaft said.

In analyzing initial rate savings on certain Treasury-indexed ARMs over a fixed-rate loan, Freddie found 5/1 hybrids create the highest savings for borrowers. In opting for a Treasury-indexed ARM amortized over 30 years with a loan amount of about $175,000, Freddie said borrowers can expect initial savings (up until the first rate adjustment) over a fixed-rate loan of up to $4,973 for 5/1 ARMs. Hybrid 3/1 ARMs reportedly generated $4,544 in initial savings, followed by $4,498 for 10/1 ARMs, around $3,881 for a 7/1 ARM, about $3,329 for 3/3 ARMs, roughly $2,245 for FHA-insured ARMs, and about $2,022 for one-year conforming ARMs. On one-year jumbo ARMs with an average loan amount of $515,000 savings are reportedly around $6,510.

Starting this month, Freddie said it will start including 5/1 hybrid ARM interest rate and fee data in its weekly Primary Mortgage Market Survey to help mortgage hunters compare costs of different loan types.

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