Consumers are getting smaller interest-payment savings on adjustable-rate mortgages compared to fixed-rate loans now that the Federal Reserve has raised short-term interest rates, a study of such loans has found.

The Freddie Mac 22nd annual adjustable-rate mortgage survey, released today, also found that greater lender discounts for introductory ARM rates are now in effect and hybrid ARMs are increasingly popular compared 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, vice president and chief economist for mortgage giant Freddie Mac.

This contributed to a rise in short-term interest rates relative to long-term rates, the economist said.

“This phenomenon is reflected in mortgage pricing as well. First-year rates on 1-year ARMs rose a full percentage point over the year … while rates on 30-year fixed-rate loans were up about one-half of a percentage point,” Nothaft said.

The survey, based on data collected Dec. 19 to Dec. 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.

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.”

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.


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