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Freddie Mac Releases Results Of Its 22nd Annual ARM Survey

January 12, 2006

Larger Initial Rate Discounts And Increased Popularity Of Hybrids

McLean, VA – Freddie Mac today released the results of its 22nd Annual Adjustable-Rate Mortgage (ARM) Survey, which found:

  • Greater lender discounts for introductory ARM rates;
  • Smaller interest-payment savings for ARMs relative to fixed-rate loans;
  • Increasing popularity of hybrid ARMs relative to one-year adjustables.
"The Federal Reserve ratcheted up short-term interest rates at each of their meetings in 2005, raising their federal funds target from 2.25 percent to 4.25 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. First-year rates on 1-year ARMs rose a full percentage point over the year; initial rates on 5/1 hybrid ARMs were up 0.8 percentage points; initial rates on 10/1 hybrids were up 0.7 percentage points; while rates on 30-year fixed-rate loans were up about one-half of a percentage point."

The survey, based on data collected December 19 to December 22, 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 2004, this discount averaged 1.4 percentage points for conventional, conforming one-year Treasury-indexed ARMs, and by the time of the survey it had increased by a half percentage point, to an average of 1.9 percentage points. Over the last 22 years, initial one-year discounts averaged about 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."

The flattening of the yield curve was clearly evident in the Treasury market over 2005: The rate spread between 10-year and 1-year constant-maturity 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 generally become less popular among families.

"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," explained Michael Schoenbeck, a business economist at Freddie Mac. "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."

Through November, ARMs accounted for about 32 percent of loan applications in 2005, according to Freddie Mac's Primary Mortgage Market SurveySM. 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 Freddie Mac's previous Annual ARM survey, the interest rate savings on ARMs are now smaller, even with the initial rate discounts that are offered by 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. "In 2005, two-in-five ARMs were 5/1 hybrids," commented Nothaft.

The average initial interest rate on 5/1 hybrid ARMs was 5.80 percent in the 22nd Annual ARM Survey, or 0.58 percentage points above the rate on the traditional 1-year adjustable, and 0.19 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 four-out-of-five lenders that offered an ARM product, the survey found. However, the traditional one-year adjustable was offered by only 56 percent of the lenders that offered ARMs, the lowest share in the 22-year history of the survey.

In all, 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 to:
  • About $1,630 for one-year conforming ARMs;
  • Around $4,840 for one-year jumbo ARMs (assuming an average loan amount of $535,000);
  • Over $890 for ARMs insured by the Federal Housing Authority (FHA);
  • Almost $990 for 3/1 ARMs (wherein the first rate-adjustment occurs in three years and then adjusts on an annual basis);
  • About $1,110 for 3/3 ARMs (wherein the mortgage rate adjusts every three years);
  • Nearly $760 for 5/1 ARMs (wherein the first rate adjustment occurs in five years and then adjusts on an annual basis);
  • Around $510 for a 7/1 ARM (wherein the first rate adjustment occurs in seven years and then adjusts on an annual basis);
  • And almost $300 for 10/1 ARMs (wherein the first rate adjustment occurs in ten years and then adjusts on an annual basis).
  1-Year ARMs 3-Year ARMs Longer Initial-Period ARMs
  1/1
Conforming
1/1
Jumbo
1/1
FHA

3/1

3/3

5/1

7/1

10/1
Loan Terms
--   --      --   P e r  c e n t a g e   P o i n t s   --   --      --
Underlying Index Rate 4.37 4.37 4.37 4.37 4.39 4.37 4.37 4.37
Margin 2.77 2.79 2.69 2.77 2.85 2.77 2.77 2.77
Fully-Indexed Rate 7.14 7.16 7.06 7.14 7.24 7.14 7.14 7.14
Initial Year’s Discount 1.92 1.87 1.71 1.49 1.67 1.34 1.18 1.04
Initial Interest Rate 5.22 5.29 5.35 5.65 5.57 5.80 5.96 6.10
Fees and Points 0.7 0.7 0.9 0.6 0.6 0.6 0.6 0.7
Fixed-Adjustable Rate Spread 0.89 0.82 0.68 0.50 0.58 0.35 0.19 0.01
Product Concentration (%) 56 42 23 73 12 80 51 26

Notes: The sample is limited to ARMs indexed to either the 1-year or the 3-year constant maturity Treasury (CMT) yields. Data were collected from 106 ARM lenders during the week ending December 23, 2005. The 3-year, 5-year, 7-year and 10-year ARM results are limited to conforming loans. The initial discount is based on the value of the weekly average 1-year or 3-year CMT yield for the comparable week ending December 23, 2005. The "Fixed-Adjustable Rate Spread" uses pricing data on the 30-year conventional conforming fixed-rate mortgage (FRM) for the calculations, and uses "effective" rates. "Effective" rates assume 4.5 percentage points (relative to the loan amount) in fees and points lower 30-year FRM interest rates by one percentage point, while 2.5 percentage points in fees and points lower ARM rates by a percentage point. Using Freddie Mac’s Primary Mortgage Market SurveySM 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.

Source: Freddie Mac



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