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Economic trends.


Consumers choose goods and services on the basis of their incomes, tastes, expectations and the prices of those goods and services. The choice of mortgage products is no different. Research suggests that the choice between an adjustable-rate mortgage (ARM) and a fixed-rate mortgage (FRM) depends mainly on consumers' tolerance for risk, the relative prices of ARMs and FRMs (i.e., differences in interest rates), the price of FRMs (i.e., interest rates on FRMs), and assessments of where interest rates have been and expectations about where they are headed.

There is no denying that the willingness to assume risk is a key factor in the ARM-FRM choice. FRM payments are known; ARM payments can increase in response to increases in interest rates.

To induce borrowers to accept this type of risk, ARM rates are typically lower than fixed rates. Because consumers respond to differences in prices, the width of the spread also influences the ARM-FRM choice. If the spread is relatively large, it offers consumers an incentive to choose an ARM over a FRM.

But the spread is obviously not the only factor. Consumers are also influenced by the level of fixed rates and where fixed rates have been in recent years. If fixed rates are low by recent historical standards, consumers may be more readily persuaded to choose a FRM and think they are getting a good deal. For example, a 10 1/2 percent FRM in 1985 would be a very hot product because rates had been over 12 percent in the past year ("10 1/2 percent looks like a great deal"). Conversely, a 10 1/2 percent rate in today's market is not attractive because rates have been well below that level in the past year ("10 1/2 percent doesn't look so great"). Clearly, then, the level of FRMs matters, and the level at which consumers think they are getting a good deal changes over time.

Finally, the ARM-FRM choice partly depends on where consumers think rates are headed. If consumers believe that rates are headed down, they are more likely to choose an ARM.

Chart 1 shows rates on ARMs and FRMs since 1987. Clearly rates on both types of products have trended down for the past several years. By October 1991, FRM rates were below 9 percent - the lowest level in 14 years - and ARM rates were below 7 percent.

The spread between the two fluctuated over that period. In 1987 and 1988, it was between 2 and 3 percentage points most of the time. It narrowed considerably in 1989, stayed fairly narrow in 1990, but opened up again in 1991.

Presently, there are conflicting influences affecting the ARM-FRM choice. FRM rates are relatively low and at extremely attractive levels compared to recent historical experience. That tends to push consumers toward FRMs. At the same time, the FRM/ARM spread is widening, which tends to push consumers toward ARMs.

Chart 2 leaves little doubt about which set of forces is prevailing. The ARM share was 23 percent of conventional loans closed in October 1991, which is quite low by historical standards.

At current levels, fixed-rates are simply too appealing for many consumers to pass up.

How would a borrower fare under various products and various interest rate scenarios? Table 1 takes a look over a seven-year time frame - the typical life of a 30-year FRM. In late November, the contract rate on an 80 percent LTV 30-year FRM was 8.6 percent. The rate on an ARM tied to the one-year constant maturity Treasury was 6.1 percent. The ARM rate is a teaser rate. Three ARM scenarios are shown. With "no change in rates," the ARM rate stays at 6.1 percent in the first year, then adjusts up to the rate reflecting the full margin in the second and subsequent years. In the next scenario, the ARM rate is assumed to rise gradually from 6.1 percent in the first year to the rates noted in the table in subsequent years. The final scenario is a worst-case one where rates jump by the full allowable caps. The only exception is in the first year of adjustment because it seems so unlikely that short-term rates will jump significantly in the next year given the sluggishness of the economy and likely Federal Reserve policy responses. The table shows APRs for the alternatives.

Table : TABLE 1 APRs of FRMs and ARMs Under Various Scenarios [Assume prepayment in 7 years]
Product Interest Rate APR
FRM 8.6% 8.60%

No change in rates(1) 6.1% 7.52%
Gradual rise in rates(2) 6.1% 8.29%
Worst case(3) 6.1% 9.84%

Note: All loans assume an 80% LTV (1) Year 1 = 6.1 percent; subsequent years = 7.49 percent. (2) Year 1 = 6.1 percent; year 2 = 7.86 percent; year 3 = 8.12 percent; year 4 = 8.62 percent; year 5 = 9.12 percent; year 6 = 9.62 percent; year 7 = 10.12 percent. (3) Year 1 = 6.1 percent; year 2 = 7.86 percent; year 3 = 9.86 percent; year 4 = 11.86 percent; years 5-7 = 12.10 percent.

If interest rates do not change, the ARM has a clear-cut advantage over the FRM because the initial ARM rate is so much lower.

Things become a bit murkier if rates are allowed to rise gradually over time. However, the ARM still appears to enjoy a slight advantage. This scenario probably is a bit unfair to the ARM. While it is extremely difficult to forecast interest rates so far into the future, such a steady rise would be unlikely unless the inflation outlook deteriorates significantly.

Finally, in the worst-case scenario, rates rise very quickly, then stay high. In this case, the ARM has clear disadvantages compared to the FRM.

The upshot is that the ARM would probably be less expensive than the FRM under the most likely scenarios. Even so, the risk exists that the ARM could be much more expensive.

PHOTO : CHART 1 Commitment Rates on Conventional Mortgage (ARM Tied to 1-YR. Treasury)

PHOTO : CHART 2 ARM Share of Home Loans Closed (Percent of Conventional Loans)
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:variable rate mortgages and fixed-rate mortgages
Author:Holloway, Thomas M.
Publication:Mortgage Banking
Date:Jan 1, 1992
Previous Article:Secondary market.
Next Article:Boardroom view.

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