ADJUSTABLE RATE MORTGAGE

Mortgage paydowns that are not tied to refinancing can be analyzed as separate investment decisions. For an adjustable-rate mortgage (ARM), a paydown reduces the remaining balance on which monthly payments are recalculated at the next payment adjustment date, thereby reducing the monthly payments for the remaining life of the mortgage. For a fixed-rate mortgage (FRM), a paydown also reduces the balance due; however, instead of the monthly payments declining, the remaining life of the FRM is shortened. The FRM paydown suffers a relative penalty because the paydown is credited to the borrower using the original mortgage rate, rather than using the higher implied forward rate with which the payments repurchased by this paydown were originally sold to the lender. With the exception of immediate paydown of the entire mortgage balance, paydowns of a specific amount early in the FRM life incur larger penalties than later paydowns of an equal amount. The paydown option is always worth more to the ARM borrower than to the FRM borrower because of this net positive FRM paydown penalty.

Traditionally, a fixed-rate mortgage (FRM) has been used for residential financing in the US. However, adjustable-rate mortgages (ARM) became an important alternative in the 1980s. When interest rates are high and expected to decline, ARM borrowers clearly fare better than those borrowers who use FRMs. The borrower is faced with the dilemma of either selecting a FRM and locking in a relatively low rate or selecting an ARM with a lower initial rate but one that may rise if interest rates rise. Few studies have focused on the effect of selecting an ARM when interest rates are low, yet it is a very important question for mortgage borrowers. A recent study selected 158 ARMs from the National Association of Realtors' Home Financing Transaction 1987 data base. A Monte Carlo simulation was developed using 1987 as the base year and the behavior of a sample of ARMs was traced over the next 16 quarters. The findings indicate that the average interest cost of ARMs was lower over the 16-quarter holding period than the average initial cost of alternative FRMs.

The adjustable-rate mortgage (ARM) mitigates the lender's risk of funding long-term assets with short-term liabilities. To realize the potential advantages of ARMs, it is critical that lending institutions know and understand the characteristics of borrowers most likely to prefer ARMs. The evidence found in a recent study contradicts the common stereotype of the young and struggling family anxious to secure an ARM to leverage its purchasing power. It was found that individuals with ARMs tend to be older and have significantly higher incomes than those with fixed-rate mortgages. They also buy more expensive homes. The evidence also indicated that the older and more prosperous ARM holders do not make a higher percentage down payment on their home. The fact that ARM holders tend to be both wealthier and older may result from their ability to withstand the risk of significantly higher mortgage payments in the near future.

Adjustable rate mortgages (ARM) account for 55.6% of the total portfolio holdings of single-family mortgages and mortgage-backed securities at savings institutions. In terms of total holdings, commercial banks are a distant 2nd, although banks hold almost as much in total home mortgage debt and mortgage-backed securities (MBS) as savings institutions. The ARM is one part of the mortgage market that has remained largely in the hands of the private sector. ARMs can be designed and priced by savings institutions largely to their own specifications. Since the end of 1990, ARM holdings have declined, while fixed rate mortgage investments have risen. A prudent course for most institutions would be to sell fixed rate mortgage originations for cash instead of in exchange for MBSs. To the extent that ARMs can be originated, these would be added to the portfolio. The consequence would be lower but more stable profits.

Declining real estate values have changed the thinking of all players in the mortgage market. Borrower conservatism is evidenced by resistence to adjustable rate mortgages (ARM) and some movement away from the standard 30-year fixed rate mortgage. Over the past 10 years, ARMs have remained constant at 10%-15% of originations, while the 30-year fixed rate has dropped to 50% of recent originations. The remainder of recent originations include fixed rate loans with 15- and 20-year terms and 7-year balloons. These more intermediate products are considered conservative, and their popularity represents a conservative trend among borrowers wanting to build equity more quickly. The slowdown in property appreciation also has caused the secondary market agencies and lenders to adopt more conservative practices.

Since its introduction in the early 1980s, the relative importance of the adjustable-rate mortgage (ARM) has varied considerably, depending to a large extent on the level of interest rates on fixed-rate mortgages (FRM) and the spread between interest rates on ARMs and FRMs. The present value framework and the term structure interest rates can be used to generate break-even points. This approach, together with the worst-case scenario method, can simplify the choice between an ARM and an FRM. A procedure is used that involves comparing the present values of the total aftertax costs of the 2 types of mortgages and selecting the one with the lower total cost. One popular index rate used for adjusting the interest rate on ARMs is the yield on one-year Treasury bills. The choice between an ARM and an FRM depends on a number of factors, including the interest rate on alternative investments. The worst-case scenarios are developed on the assumption that the ARM rate will increase by the annual interest rate cap each year until the ARM rate reaches the initial rate plus the lifetime cap.

Home mortgage lenders are having difficulty achieving adequate returns on adjustable-rate mortgage (ARM) loans. Lenders must balance several variables in pricing ARMs, and combining these variables into a specific mortgage product with acceptable risk-reward characteristics has been complicated. ARMs have 3 primary risks: 1. interest rate, 2. default, and 3. prepayment. During periods of rising interest rates, the interest received by the ARM may lag below the increases in the lender's costs of funds. Lenders try to design various ARM features in order to eliminate a lag. However, aggressive ARM pricing features can give the borrower 'payment shock' and may increase the risk of default if the borrower is unable to meet increased payment requirements. The pricing problem is examined by simulating the yields of 3 ARMs, each with significantly different features.

The decision to refinance an existing mortgage is a consideration faced by a homeowner when interest rates decline. This is particularly true for homeowners who want to cut their house payments and their ties to fickle adjustable rate mortgages (ARM). For homeowners with ARMs that start with low interest rates the first year and higher rates in succeeding years, refinancing offers more than securing a steady rate of interest. It brings peace of mind and the opportunity to save a substantial sum of money. A model is presented that will assist a financial adviser in providing refinancing information for a customer or enable individual homeowners to make this decision for themselves. One simply compares the refinancing yield to that of comparable market investments and selects the more competitive rate. If the recovery period and nominal dollar savings are acceptable, then refinancing the mortgage should prove to be an economically justifiable decision.

One of the most significant innovations in residential real estate finance was the adjustable-rate mortgage (ARM). During the early 1980s, ARMs were popular with home buyers, but as interest rates dropped, the attractiveness of ARMs declined. A survey was conducted to examine consumer preferences toward both adjustable-rate and fixed-rate mortgages and to measure home buyers' attitudes toward the home-buying process. The results of the survey confirm that the principal attraction of fixed-rate mortgages is the certainty that the interest rate will not change in the future. However, a majority of respondents with fixed-rate mortgages indicated that they would choose an ARM if the initial interest rate were at least 1.5% to 2% below that of a fixed-rate mortgage. When selecting a mortgage company, 33% of the respondents made their selection as a result of shopping for the lowest interest rate, while 26% took their real estate agent's recommendation.

From the lender's perspective, convertible adjustable rate mortgages (CARM) are attractive, because they convert to fixed rates that are higher than prevailing fixed rates at the time of conversion. CARMs must be priced so they are competitive with the other alternatives available to the borrower. The options to be considered are:

1. Take and hold a fixed rate mortgage (FRM). 2. Take an FRM, then refinance to a new FRM. 3. Take and hold an ARM. 4. Take an ARM initially, then refinance to a new ARM. 5. Take and hold a CARM. 6. Take a CARM initially, then convert to an FRM.

Assuming that the loan is held to maturity, the highest cost option is the buy and hold strategy with the ARM and CARM. If the loan will be held for only 5 years, the option of primary interest is the CARM with conversion. Under a 5-year holding period, the CARM conversion option results in the least cost for the borrower. The best option from the lender's standpoint is the borrower taking an FRM and refinancing after a year to a new FRM. The major implication for lenders from this comparison is that CARMs may be a way to stabilize yields across holding periods so that prepayment becomes less of a problem.

The recent introduction and widespread acceptance of adjustable-rate mortgages (ARM) in the US has generated a great deal of controversy regarding both their potential credit risk and their use in managing interest rate risk. Of particular interest is the question of whether the default and prepayment experience with ARMs will differ significantly from that with fixed-rate mortgages (FRM). The Canadian experience with ARMs is used to estimate a model of mortgage repayment behavior. The results of this estimation permit the first empirically based comparison between FRM and ARM borrower behavior. Results suggest that the default risk of ARMs in the US is likely to be higher than that of FRMs. This is due to the fact that mortgage-related capital gains are less likely with frequently adjusting ARMs, and that, by their design, ARMs have the potential for increased real contract rates. Results also suggest that complete prepayment is likely to be lower with ARMs because the contract rates on these instruments are typically closer to market.

A new scholarly study conducted by the Office of Real Estate Research of the University of Illinois, Champaign-Urbana, confirms that adjustable-rate mortgages (ARM) help smooth out the housing cycle. The results indicate that when fixed-rate mortgages are high compared to ARMs, ARM borrowers buy 'less house.' This suggests that ARM borrowers prepare themselves in advance for higher monthly payments when they see indications of higher rates. Home buyers who finance with an ARM generally buy 12% more house than those financing with a fixed-rate mortgage. As a result, ARMs stimulate the demand for housing and can benefit both consumers and housing. At interest rate peaks, ARMs keep demand from declining as drastically as would be the case if fixed-rate mortgages were the only option. Therefore, fewer buyers wait for interest rates to decline, and there is greater moderation in housing swings.