Will Interest Change Lead to Higher ARM Share?

The adjustable-rate mortgage (ARM) share of home mortgages has bottomed out. The fall in ARM market share is directly attributable to the dramatic drop in interest rates on fixed-rate loans, which hit a 45-year low this June. The ARM share of conventional originations slipped to 13 percent in June and July, well below its peak of 69 percent back in October 1987 and more recent high of 59 percent in January 1995. The rise in interest rates on fixed-rate loans since June, especially relative to initial rates on ARMs, signal a probable resurgence in ARM market share. The ARM share of new applications has already edged above 20 percent and could represent one-quarter of originations in 2004.

Families Respond to Relative Price Differences

A basic tenet of economics is that consumers will generally want more of a product if its price is lower, or if the price of a substitute good is higher. This same principle holds true in credit markets. The interest rate on a loan can be thought of as the "price" of credit (a borrower would think of it as the "cost" of the loan). A family that is in the market for a home mortgage will need to choose between a fixed-rate and an adjustable-rate loan. These are the two major options available in our mortgage market, and each serves as a substitute for the other. As interest rates on fixed-rate loans decline (and assuming ARM "prices" remain unchanged), a larger share of families will apply for fixed-rate loans. Likewise, a larger proportion of borrowers will opt for fixed-rate loans if the initial rate on ARMs increases (assuming fixed-rate "prices" remain unchanged).

Exhibit 1 illustrates the strong correlation between the level of interest rates on fixed-rate loans and the ARM share of originations. In November 1994, interest rates for fixed-rate product hit 9.2 percent, while the rate on a one-year ARM was 3.1 percentage points lower, and the ARM share exceeded 50 percent for a few months. Empirical studies have found that for each percentage point drop in mortgage rates, the ARM market share falls 5 to 10 percentage points. Over the past few years, as interest rates have declined, the "price" of fixed-rate mortgages has fallen, and the ARM share has generally fluctuated between 10 and 20 percent of originations. Since the end of June, interest rates have risen about 1.25 percentage points on fixed-rate loans and only 0.50 percentage points on one-year ARMs, making the ARM product a more attractive alternative for consumers.

The ARM Share Is Much Higher in the Jumbo Market

The higher ARM share of jumbo originations is another example of the response of consumers to relative price differences. Interest rates on jumbo fixed-rate loans may be 0.50 percentage points or more above the rates on conforming fixed-rate mortgages, whereas ARM rates on jumbo and conforming product tend to be very close. Jumbo-loan borrowers respond to the larger pricing difference between the two products by choosing ARMs more often. As shown in Exhibit 2, the ARM share of lending in the jumbo market is much greater than in the conforming market.