Adjustable-Rate Mortgages Likely to Gain Favor with Borrowers

Since the onset of the mortgage crisis, homebuyers have shied away from adjustable-rate mortgages (ARMs) because they are wary of the risks, but these loan products are slowly gaining back lost market share, according to Frank Nothaft, VP and chief economist for Freddie Mac.

“The potential for much larger payments if future interest rates are significantly higher and the high delinquency rates borrowers have experienced on ARMs over the past couple of years have led consumers to prefer fixed-rate loans instead of ARMs,” Nothaft explained. “In addition, fixed-rate loans currently carry extraordinarily low rates, and initial ARM rates are only slightly lower, making fixed-rate product more attractive.”

In June 2004, ARMs hit a peak share of 40 percent of the home-purchase market but by early 2009, that share had fallen to just 3 percent, Nothaft said. Today, ARMs are financing approximately 7 percent of new home-purchase loans, according to an annual study released by Freddie Mac Tuesday.

And Nothaft says he expects ARMs to “gradually gain back some favor with mortgage borrowers, rising to an average 9 percent share of the home-purchase market in 2011.”

Based on Freddie Mac’s newly published ARM study, for the third consecutive year, lenders quoted an initial rate that was above the fully-indexed rate on most ARM products. This means that even if short-term Treasury rates remain where they are, the first-rate adjustment would actually lower a homeowner’s mortgage payment, the GSE explained.

In early January 2011, the interest rate savings between the initial start rate for traditional 1-year ARMs and 30-year fixed loans amounted to about 1.5 percentage points, compared to 0.8 percentage points in January 2010, Freddie Mac reported.

The GSE found that 5/1 hybrid ARMs continue to be the most popular loan product offered by lenders. Nearly all of the ARM lenders participating in the survey offered such a loan.

The second most popular adjustable-rate loan among lenders was the 3/1 hybrid ARM, with more than seven in 10 lenders offering the product. Only 9 percent of lenders offered a 3/3 ARM loan, which adjusts once every three years.

Longer-term hybrid products, such as the 7/1 and 10/1 ARMs, were also available from lenders, consisting of 64 percent and 23 percent of the survey participants, respectively. Because of the long initial fixed-rate period (seven or 10 years), the initial interest rates were priced close to the rate on a 30-year fixed-rate loan for these products.

Among 112 ARM lenders, 71 percent offered loans tied to constant-maturity Treasury yields; the remaining offered products with future rates indexed to the London Interbank Offered Rate (LIBOR), Freddie Mac said.

With the onset of the financial crisis, the difference between the 1-year LIBOR interest rate and the 1-year constant maturity Treasury yield peaked at just over 3 percentage points in October 2008. LIBOR-indexed ARMs that adjusted at that time may have adjusted up or did not adjust materially down, compared with Treasury-indexed ARMs, the GSE explained.

Freddie Mac says the uncertainty over LIBOR movements may have led some current borrowers to avoid LIBOR ARMs. Currently, the interest rate difference stands at around 0.5 percentage point between the two indexes.

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