Adjustable-rate mortgages accounted for 34 percent of the conventional purchase-money market in 2004, which is the second highest annual share since 1994 when the share was 39 percent, according to an annual survey released by Freddie Mac

Initial rates on ARMs rose by about 40 basis points over the course of the year because they typically are priced off of financial instruments with shorter maturities that match the length of the initial adjustment period, said Frank Nothaft, vice president and chief economist for Freddie Mac.

“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,” Nothaft said. “The larger initial discounts increase the initial rate benefit of an ARM compared with fixed-rate loans, helping lenders to maintain ARM originations. Long-term mortgage rates were little affected, averaging about the same at the end of the year as they did in the beginning.”

The survey, based on data collected Dec. 20-23, 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 encourage homeowners to opt for 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 beginning of 2004, this discount amounted to about three-eights of a percentage point for conventional, conforming one-year Treasury-indexed ARMs and by the end of the year it had increased by almost a full percentage point, to an average of 1.34 percentage points. Over the last 21 years, initial one-year discounts averaged about 1.7 percentage points.

Overall, the survey found greater lender discounts for introductory ARM rates; smaller interest-payment savings for ARMs relative to fixed-rate loans; and increasing popularity of hybrid ARMs relative to one-year adjustables, Freddie Mac reported.

There was a steep Treasury yield curve at the start of 2004, with the rate spread between 10-year and one-year constant-maturity yields at 2.91 percentage points, yet the year around 1.57 percentage points. During periods of a steep yield curve, ARMs become more popular among consumers, according to the Freddie Mac announcement.

“For instance, in 2004 the ARM share of mortgage originations peaked in June at 40 percent of conventional home-purchase loan activity,” said Nothaft. This followed a 2.94 percentage point high for the year in the 10-year to one-year treasury rate spread in May.

Compared with Freddie Mac’s previous Annual ARM survey, the interest rate savings on ARMs is now smaller, even with the initial rate discounts that are offered by lenders. For example, the one-year adjustable carried a rate that was 2.0 percentage points below a 30-year fixed-rate loan in the last survey, but only 1.6 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. According to the FHFB data, hybrid ARMs accounted for the majority of purchase-money ARMs by 2002. 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 2004, two-of-five ARMs, and three-of-five hybrids, were 5/1 ARMs,” commented Nothaft. “Starting this week, Freddie Mac has begun collecting 5/1 hybrid ARM data in our weekly Primary Mortgage Market Survey, and will begin releasing the data this month. This will provide families with additional information on the interest rates and fees associated with 5/1 hybrids, to help them as they compare costs of different loan types,” he added.

The average initial interest rate on 5/1 hybrid ARMs was 4.99 percent in the 21st Annual ARM Survey, or 0.82 percentage points above the rate on the traditional 1-year adjustable, and 0.65 percentage points below the rate on a 30-year fixed-rate mortgage. “Hybrid ARMs provide 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.

In general, ARM rates are lower than the tradition 30-year FRMs owing to the homeowner exposure to the inherent interest-rate risks of periodic adjustments. For hybrid ARMs, rates are higher than one-year ARMs. However, once the first rate-adjustment occurs, subsequent annual rate adjustments are virtually the same, owing to similar margins across these loan options. The biggest difference depends on the course of future one-year Treasury rates and the embedded interest rate caps. But if interest rates remain relatively stable, then all of these ARMs will ultimately converge to the same interest rate over time.

In all, potential home buyers and existing homeowners opting for a Treasury-indexed ARM amortized over 30 years with a loan amount of about $175,000 can expect initial savings (up until the first rate adjustment) over a FRM of up to:

  • About $2,022 for one-year conforming ARMs;

  • Around $6,510 for one-year jumbo ARMs (assuming an average loan amount of $515,000);

  • Roughly $2,245 for ARMs insured by the Federal Housing Authority (FHA);

  • Almost $4,544 for 3/1 ARMs (wherein the first rate-adjustment occurs in three years and then adjusts on an annual basis);

  • About $3,329 for 3/3 ARMs (wherein the mortgage rate adjusts every three years);

  • Nearly $4,973 for 5/1 ARMs (wherein the first rate adjustment occurs in five years and then adjusts on an annual basis);

  • Around $3,881 for a 7/1 ARM (wherein the first rate adjustment occurs in seven years and then adjusts on an annual basis);

  • And almost $4,498 for 10/1 ARMs (wherein the first rate adjustment occurs in 10 years and then adjusts on an annual basis).

Freddie Mac, a stockholder-owned corporation established by Congress in 1970, purchases mortgages from lenders and packages them into securities that are sold to investors.


Send tips or a Letter to the Editor to or call (510) 658-9252, ext. 137.

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