“Are some types of mortgages priced better for the borrower than others?”

If you qualify for prime lending terms, there isn’t much reason to select an adjustable-rate mortgage (ARM) in the current market. For most such borrowers, the temporary rate benefit in the early years is too small to justify the risk of higher rates later on.

This is a consequence of what has been referred to as a “flattening of the (bond) yield curve.” The yield curve is a graph that shows, at any given time, how the yield varies with the period to maturity. A flat yield curve means that yields on long-term bonds are not much higher than those on short-term notes.

Bond markets affect mortgage markets, and vice versa, because a large part of all new mortgages are converted into mortgage-backed securities (MBSs), which investors view as close substitutes for government securities and high-quality corporate bonds. Developments in the MBS market, in turn, are immediately reflected in the primary mortgage market where individual borrowers obtain their loans.

When the bond yield curve flattens, the mortgage yield curve facing borrowers flattens as well. This means a marked reduction in the rate differences between fixed-rate mortgages (FRMs) and ARMs. It also means smaller rate differences between FRMs with different terms.

I did my own online rate survey on Oct. 8. It covered what loan originators call a “cream-puff” loan — one with no complications. It was a no-cash refinance for $320,000 on a single-family property used as permanent residence and valued at $400,000, to a borrower with good credit who can fully document an adequate income. I used the 30-year fixed-rate mortgage as the base, and measured rate differences with other mortgage types when points and other loan fees were the same.

The most interesting result was that the rate on the 30-year FRM was only .25 percent higher than that on a 3/1 ARM — for example, 6 percent compared with 5.75 percent. The lower rate on this ARM holds for three years, after which it is adjusted on an annual schedule.

More likely than not, the rate on this ARM will increase at the first adjustment. The new rate will be the value of the rate index at that time plus a margin, which remains the same over the life of the loan. We don’t know what the index will be in three years, but we know that right now it is about 5.25 percent, and a competitive margin is about 2.25 percent. This means that if the market doesn’t change over the next three years, the new rate on the ARM will be about 7.5 percent. A .25 percent rate difference for three years hardly seems like adequate compensation for the additional risk. 

Since the 3/1 ARM is not a good choice, the same conclusion holds for 5/1, 7/1 and 10/1 ARMs on which the initial rates hold for five, seven and 10 years, respectively. The rate advantage over the 30-year FRM, if any, is smaller than .25 percent.

Among FRMs with different terms, rate differences are much smaller than in years past. The 15-year and 10-year FRMs are priced only about .3 percent and .4 percent, respectively, below the rate on a 30-year. The shorter term FRMs remain the better deal, but the reward for borrowers who can afford the higher payments is smaller than it used to be.

The 40-year FRM, in contrast, is priced at about .4 percent above the 30 and is a poor deal. Borrowers who need a payment below the one on a standard 30-year would do better with the interest-only version of the 30. It is priced only about .1 percent above the standard 30 and carries a lower payment than the 40.

These observations don’t apply to subprime borrowers, most of whom will continue to obtain ARMs because they will be offered nothing else. The most common subprime ARM is the 2/1 (the initial rate holds for two years), which will typically have margins of 5 percent or more and carry a penalty for early prepayment.

Another category of borrowers unaffected by recent market changes are those fixated on getting the lowest initial payments available in the market. They will continue to select option ARMs on which the payments don’t cover the interest in the early years. Option ARMs carry margins 1 percent to 1.5 percent above those on other ARMs because lenders view the default risk as higher.

Of course, what to the lender is a high risk of default and loss, to the borrower is a high risk of losing the house. Most borrowers who take option ARMs make the minimum payment, which leads inevitably to payment increases down the road that may be too large for the borrower to handle. (For more, see the tutorial on option ARMs on my Web site.)

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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