Claus Lund is a financial-services consultant, located in
northern California. He works with mortgage bankers and
consumer-lending companies to improve their pricing and
capital-markets functions, obtain agency seller/servicer
approvals, set up agency and Ginnie Mae mortgage-backed
securities programs, make sub-servicer arrangements and
co-issue agreements and create in-house or external
hedging programs. Reach Lund at (415) 250-3240 or
Carry ARMs in Your Quiver
Adjustable-rate mortgages are a valuable weapon against rising rates
By Claus Lund
Disruption, the trendy phrase in the fintech world, describes the expected impact of new web-based technologies on current lending practices in fundamental ways.
Mortgage originators experienced another type of
disruption this past November when interest rates
jumped above 4 percent for the first time in almost
two years, spoiling the cozy world of endless refinancing in a historically low interest rate environment.
Many originators neglected to cultivate the purchase market because of the easier pickings of low-hanging refi fruit. The unending growth they had
come to expect was steamrolled by rate hikes,
replaced by slim application volumes and thinning
Increasing tensions from decreasing production
numbers and increasing fixed costs were alleviated
slightly by refi stragglers, while recent dips in interest rates provided some relief in the form of cash-out
refis. With interest rates forecasted to continue rising,
however, it will become harder and harder to convince
borrowers to refinance at a higher rate than their current mortgage, even to tap into their home’s equity.
Mortgage originators excel at finding products that
help people purchase their dream home, which is what
the mortgage business is all about. One product that
meets many niche needs is the hybrid adjustable-rate mortgage, or ARM, which was introduced in the
early 1990s by a large West Coast bank to make high-priced California homes affordable.
A hybrid ARM shortens the duration of a 30-year
fixed-rate loan by creating a loan with a fixed initial
period of three, five, seven or 10 years and a reset to an
annual or semi-annual adjuster based on a short-term
index such as the six- or 12-month Libor.
The shorter duration allows the loan to be priced
lower over the front end of the curve, so it is the yield
curve that determines the viability of these loans.
A flat or inverse curve makes them uncompetitive,
while a steep curve makes them more viable.
If the federal funds rate is at 1 percent and 10-year
Treasury rate is 2.25 percent, for example, the
30-year fixed rate will likely be 3.875 percent, while a
5/1 ARM would be around 2.875 percent. Many borrowers will accept the additional 1 percent interest
for the certainty of a — still historically — low rate for
the duration of their loan.
Now let’s assume the Fed continues its tightening regime — which seems likely over the next few
years — and the federal funds rate goes to 1.50 percent.
Increased uncertainty tends to steepen the curve,
this point, short-term spreads will tend to stay put
while longer-term spreads will widen. So in this envi-
ronment, the 30-year fixed rate could increase to
5. 75 percent, while the 5/1 ARM rate might only rise to
3.375 percent, making it far more attractive.
No originator needs to be told that ARMs are a
great choice for their borrowers when rate spreads
get this far apart. In general, the higher fixed mortgage rates get, the better ARMs look to borrowers
concerned with affordability, which explains why the
market share of ARMs often exceeded 40 percent in
California in the 1990s and hit 25 percent nationwide
before the crisis. Today, ARMs account for only around
10 percent of total origination volume.
Affordability was the initial driver for ARM products
back in their heyday, and these loans are still particularly well-tuned to the jumbo market. The reason is
Using the hypothetical interest rates described
earlier, a borrower who takes out a $900,000 loan
in the low-rate scenario will have a monthly payment of $4,232 on a 30-year fixed and $3,734 on the
5/1 ARM, a difference of $498. In the higher-rate scenario, where the yield curve steepens, the 30-year
fixed-rate borrower pays $5,252 monthly while the
5/1 ARM borrowers pays $3,979. This is a difference
of $1,273, or an annual saving of more than $15,000.
The homebuyer using a hybrid ARM loan, because of
its favorable front-end pricing structure in a rising-rate environment, can afford a lot more home than
the 30-year fixed-rate borrower.
It is fairly easy to sell the savings advantages of
ARMs for jumbo loans, especially as interest rates rise,
but purchase-market originators need to understand
the other areas where ARM loans make sense. This
will allow them to better align their marketing to the
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