A study released by Freddie Mac today shows the impact of the housing slowdown on lending practices, including a decline in ARM share of overall lending, as the interest-rate savings relative to fixed-rate loans has shrunk. The 23rd Annual Adjustable-Rate Mortgage (ARM) Survey of prime loans also found greater lender discounts for introductory ARM rates and an increasing popularity of hybrid ARMs relative to one-year adjustables. "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," said Frank Nothaft, Freddie Mac vice president and chief economist.
"This contributed to a rise in short-term interest rates relative to long-term rates. This phenomenon is reflected in mortgage pricing as well with products that re-price more frequently showing the largest increases in interest rates," Nothaft said. "First-year rates on 1-year ARMs rose about 0.3 percentage points over the year; initial rates on 5/1 hybrid ARMs were up 0.2 percentage points; while initial rates on 10/1 hybrids and rates on 30-year fixed-rate loans ended 2006 at about the same level where they had begun the year." The survey, based on data collected December 18 to December 21, found that starting rates for ARMs would have increased even further were it not for greater use of initial-rate discounts by lenders. In order to increase borrowers' financial incentive to choose an ARM, lenders typically offer a lower initial interest rate than what the fully-adjusted rate would be at the time of origination, i.e., the underlying index rate plus the margin. At the end of 2005, this discount averaged 1.9 percentage points for conventional, conforming one-year Treasury-indexed ARMs, and by the time of the survey it had increased by 0.4 percentage points, to an average of 2.3 percentage points. The last time initial rate discounts were higher was during 1997. Over the 23-year history of the survey, initial discounts on one-year ARMs have averaged 1.7 percentage points. "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," observed Nothaft. "The larger initial discounts increase the initial rate benefit of an ARM compared with fixed-rate loans, helping lenders to maintain ARM originations." ARMs accounted for 25 percent of loan applications in November 2006, according to Freddie Mac's 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. "Consumers are financially savvy and respond to changes in the relative cost of different loan products. As ARMs became more expensive relative to fixed-rate loans during 2006, the ARM share of lending declined," explained Nothaft. 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. "In 2006, two-in-five ARMs were 5/1 hybrids," commented Michael Schoenbeck, a business economist at Freddie Mac. In contrast, as recently as 1999, two-in-five ARMs were the traditional one-year adjustable. The average initial interest rate on 5/1 hybrid ARMs was 5.96 percent in the 23rd Annual ARM Survey, or 0.5 percentage points above the rate on the traditional 1-year adjustable, and 0.2 percentage points below the rate on a 30-year fixed-rate mortgage. "A 5/1 hybrid ARM provides 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 observed. The 5/1 hybrid was available at five-out-of-six lenders that offered an ARM product, the survey found. However, the traditional one-year adjustable was offered by only 52 percent of the lenders that offered ARMs, the lowest share in the 23-year history of the survey.