Hybrids and Discounts Are Hot

Special Commentary from the Office of the Chief Economist
by Frank E. Nothaft, Freddie Mac's chief economist
February 14, 2005

No, this article is not an analysis of trends in the automobile market, although hybrids and price discounts are hot there, too. But similar to the new car market, hybrids and rate discounts have also been driving forces in propelling adjustable-rate mortgage (ARM) lending volume over the past year. The most popular ARM in the marketplace today is the hybrid, which blends an extended initial fixed-rate period (commonly 5 years, although other periods are available) with annual adjustments after the initial period, thus a "blend" of a fixed- and an adjustable-rate loan. ARMs are typically offered with an initial-rate discount, that is, the initial interest rate is less than the "fully-adjusted" (index plus margin) rate.

5/1 Hybrids Are Two-Fifths of All ARMs

Long-term, fixed-rate loans remain the product of choice for the American consumer, accounting for 65 percent of all conventional home-purchase loans in 2004. But within the ARM product line, adjustables have come in various shapes and sizes over the years, with different features to satisfy the needs of consumers and the returns required by investors. Because of the strong consumer desire for long-term, fixed-rate credit, lenders have offered various ARM products that feature lower initial interest rates but also serve the ultimate need for a fixed-rate loan.

Not long ago, "convertible" ARMs were commonplace, permitting the consumer to "convert" the ARM into a fixed-rate loan at prevailing market rates for a nominal fee. Convertibles are far less prominent today, having been supplanted by hybrids. Hybrids typically have initial fixed-rate periods of 3, 5, 7 and 10 years, while still amortizing over a 30-year term. In 2004, "5/1 hybrids," which have an initial 5-year fixed rate, were the most popular ARM product, accounting for two-fifths of all ARMs (Exhibit 1).

Exhibit 1: 5/1 Hybrids Dominate ARM Market

Rate Discounts Have Increased Over the Past Year

Consumers shopping for a loan respond to market prices, just like they do when shopping for any other item. When fixed-rate mortgages are inexpensive relative to ARMs, consumers flock to fixed-rate product, as was true in 2003 when interest rates on fixed-rate loans were at a 45-year low. (See "Will Interest Change Lead to Higher ARM Share?" Special Commentary, September 2003.) Since June 2004, the Federal Reserve has been gradually nudging short-term interest rates higher, causing a corresponding increase in all other rates that are based on these, such as interest rates on ARMs. To maintain consumer interest in ARMs, many lenders have offered an interest-rate discount for an initial period of the loan -- often a rate discount that lasts until the first interest-rate adjustment. The use and extent of such discounts has increased over the past year: For a one-year, Treasury-indexed ARM, the initial discount has increased from an average of 0.4 percent in January 2004 to 1.50 percent in January 2005.

An initial rate discount, a common feature in the ARM market, is measured by taking the difference between the fully adjusted interest rate and the actual initial interest rate that the consumer pays. During periods when the interest rate on a 30-year, fixed-rate loan is at or below the fully adjusted ARM rate, rate discounts can get quite large. Exhibit 2 shows a distinct inverse relationship between the size of the rate discount (blue curve) and the flatness of the mortgage yield curve (green curve, as measured by the difference between the 30-year, fixed-rate and the fully adjusted 1-year ARM). Rate discounts will likely continue to be a mainstay of the ARM market in 2005, slowing the effect of the Fed’s increase in short-term rates in reducing ARM origination volumes.

Exhibit 2: ARM Rate Discounts Increase When Yield Curve Flattens