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The borrower's dilemma.


The typical lender's product menu today almost certainly offers some kind of convertible adjustable rate loan (CARM).

CARMs have existed since the early 1980s when they were introduced along with other types of adjustable rate loans. But their use is not widespread. This probably results from borrowers' difficulty in understanding the loan's complexities and the uncertainty for borrowers and lenders in pricing the conversion feature. A convertible ARM allows the lender to convert from an adjustable rate loan (ARM) to a fixed-rate mortgage (FRM) within a specified conversion window. This period is usually the 13th through the 60th month of the life of the loan.

A borrower must decide if it is beneficial to pay the conversion fee (usually a nominal amount of $250) and transform the note to fixed-rate, fixed-payment. This decision requires the borrower to figure out which alternative will minimize financing costs. This means that the borrower must not only be capable of deriving and comparing the effective cost under different alternatives, but he or she must also make subjective decisions about future interest rate movements. Certainly, not an easy task for anyone.

Because the lender is concerned with maximizing the effective yield on mortgage lending, yields for the different alternatives must be compared. If yields are competitive, CARMs may be attractive to lenders because they require less paperwork to process and can reduce credit risk by making payments certain and/or lower.

Also, from the lender's perspective, CARMs may be attractive because they convert to fixed rates at the time of conversion. The usual procedure is to convert the loan at a rate that is either the current fixed rate or the FNMA 60-day delivery quote plus a 3/8 to 5/8 percent premium.

Let's compare the effective cost of the CARM with the FRM and ARM based on historical pricing. The lender must price the CARM based on current market conditions relative to expected future conditions. The CARM must be priced to be profitable for the lender and, at the same time, attractive to the borrower. This analysis will allow the lender to compare the costs of the various alternatives using actual data and interest rate movements over a certain time period.

The convertible ARM

When a convertible ARM is written, this could result in the lender having two contact points with the borrower (when the loan is made and when the CARM is converted to a FRM). As Ferreira and Sirmans pointed out recently (in their unpublished paper "Borrowing and Lending in the Mortgage Markets" 1990), the lender must price the convertible mortgage with the understanding that either an increase or decrease in interest rates could trigger a conversion. The borrower may convert if rates increase and there appears to be a continuing upward trend. On the other hand, if rates decline, conversion may occur when the borrower thinks that rates have bottomed out. The lender understands that the motivation to convert is a factor in pricing the CARM and that the biggest disadvantage of the conversion is that it allows the interest rate risk to be shifted all or in part back to the lender.

CARMs must be priced so they are competitive with the other alternatives available to the borrower. For example, it could be cheaper for the borrower to take a series of ARMs and simply refinance periodically to continually buy down the rate; or pursuing a buy and hold strategy on a fixed-rate mortgage may be more worthwhile.

Using actual lender-quoted rates, the costs of the various alternatives can be calculated and compared. The options to be considered are: * Take and hold a FRM. * Take a FRM initially, then refinance to a new FRM. * Take and hold an ARM. * Take an ARM initially, then refinance to a new ARM. * Take and hold a CARM. * Take a CARM initially, then convert to a FRM.

These alternatives will be considered during the period November 1988 (when the initial rates were quoted for the alternatives) to November 1989 when the decision must be made whether or not to shift or convert to another type of loan. The rates quoted are from a large mortgage lender in a southeastern city and are representative of the area rates quoted for these types of loans at the time.

Table 1 presents the quoted rates and terms for the various financing alternatives for November 1988 and November 1989. The table illustrates that the yield curve during this time became flatter as fixed-rate mortgage rates declined, and rates on adjustable rate and convertible adjustable rate loans increased. The points charged on FRMs declined while the points charged on ARMs and CARMs remained constant. The convertible mortgage converts to a fixed-rate which is the FNMA 60-day delivery quote plus 5/8 percent premium.

Table : TABLE 1

Quoted Rates and Terms for FRMs, ARMs and CARMs
 November 1988 November 1989
Contract Rate 10% 7.75% 7.75% 9.5% 8.75% 8.75%
Points* 2.75 2.50 .50 2.50 2.50 2.50
Term/yrs 30 30 30 30 30 30
Margin -- 2.75 2.75 -- 2.75 2.75
Caps -- 2/6 2/6 -- 2/6 2/6
Conv. Time/Mnth -- -- 13-60 -- -- 13-60
Conv. Fee -- -- $250 -- -- $250
Conv. Rate** -- -- FM+5/8 -- -- FM+5/8

* The quoted points include discounting and origination fees. ** FM+5/8 indicates that the rate at which the loan converts to fixed is the Fannie Mae 60-day delivery quote plus 5/8%.

Costs of alternative financing

Table 2 presents the effective costs (calculated as the annual percentage rate [APR]) for the various alternatives. The costs are calculated for two holding periods: (1) Assuming that the loan is held to maturity and (2) assuming that the loan is held for five years. It is important to distinguish the holding period because once discount points are introduced, the cost is affected by the length of time the borrower holds the mortgage.

The costs presented in Table 2 allow a comparison of the cost of the CARM relative to the alternatives. Assuming that the loan is held to maturity, the highest cost option is the buy and hold strategy with the ARM and CARM (10.88 percent). Note that since the entry fees for the CARM are the same as for the ARM, these two options will entail the same cost. This calculation assumes a worst case scenario with maximum rate adjustments for the first three years. Thus, the contract rate was 7.75 percent in the first year, 9.75 percent in the second year and 11.10 percent for the third through the thirtieth years. The one-year Treasury bill yield was 8.35 percent at the end of the first year and this rate was assumed to stay constant over the remaining life of the loan.

Note that the cost of the ARM would be even higher if the index increased, driving the contract rate to the 6 percent lifetime cap. If the borrower simply took and held a FRM, the effective cost would be 10.33 percent. However, due to the way that interest rates moved, FRMs were priced one year later in a way that would have produced an effective cost to the borrower of 10.28 percent if the borrower opted for a new FRM by refinancing. Thus, it would have been cheaper for the borrower to refinance and incur the additional costs to buy the contract rate down.

The most expensive option would have been to take an ARM, then refinance to a new ARM at the end of the year. Because the contract rate on the ARM went from 7.75 percent to 8.75 percent over the year with no reduction in discount points, the effective cost increased to 11.13 percent. Again, the index yield was assumed to stay constant at 8.35 percent, thus the contract rates would be 7.75 percent for year one, 8.75 percent for year two, 10.75 percent for year three and 11.10 percent for years four through thirty.

The option of primary interest for the scope of this article is the CARM. With the observed movement interest rates, converting to a FRM at the end of the first year would produce an APR of 10.41 percent. This option is less expensive than choosing an ARM but is more expensive than simply taking a FRM at the outset and holding it or taking a FRM then refinancing to a FRM.

If we assume the loan will be held for only five years, the scenario changes somewhat. As column three of Table 2 shows, the option that was cheapest before now becomes the most expensive. If the borrower takes a FRM then refinances after one year, the effective cost is 11.19 percent. Simply taking and holding a FRM results in a cost of 10.72 percent. Taking and holding an ARM or CARM for the five years produces a cost of 10.63 percent. If the borrower were to refinance with a new ARM, the cost would be 11.13 percent.


Effective Costs of Different Financing Options for Various Holdings Periods
 Effective Cost (%)
 Held to Held Five
Option Maturity Years

1. Take and Hold FRM (Nov. '88) 10.33% 10.72%

2. Take FRM (Nov. '88), then refinance to

FRM After 1 yr.* 10.28% 11.19%

3. Take and Hold ARM (Nov. '88) 10.88% 10.63%

4. Take ARM (Nov. '88), then Refinance to

ARM After 1 yr. 11.13% 11.17%

5. Take and Hold CARM (Nov. '88) 10.88% 10.63%

6. Take CARM (Nov. '88), then Convert to

FRM After 1 yr. 10.41% 10.44% * In instance of refinancing, it was assumed that the borrower had total fees of $1,000 over and above discount points. This would include the cost of such items as the appraisal, survey and other clearing costs.

Again, the option of primary interest is the CARM with conversion. If the borrower converts at the end of year one and holds the mortgage for four more years, the effective cost is 10.44 percent. This cost is consistent with the cost of holding to maturity and this is one option that did not have a significant change in cost with a change in the holding period. The only comparable option is the ARM with refinancing to an ARM. This, however, is not a viable option because borrowers would have no incentive to refinance to a higher contract rate.

Under a five-year holding period, the CARM conversion option results in the least cost for the borrower (which is, alternatively, the lowest yield for the lender). As a lending strategy then, if shorter holding periods are anticipated, lenders would not want to write CARMs priced with these quoted terms under these market conditions. The best option from the lender's standpoint is the borrower taking a FRM and refinancing after a year to a new FRM. This would be the case even though rates on FRMs decreased over the year. The borrower may mistakenly think that borrowing cost is being minimized because that is indicated when a holding period to maturity is assumed. However, this is certainly not the case with a shortened holding period.

Table 3 compares effective costs for the CARM under different interest rate scenarios. As shown, based on the actual drop in rates on FRMs from 10 percent to 9.50 percent, the effective cost is 10.41 percent if the loan were held to maturity and 10.44 percent assuming a holding period of only five years. This assumes that the CARM is converted at the end of the first year.

Table : TABLE 3

Comparison of Effective Cost of CARM under Different Rate Movements with Conversion after One Year
 Effective Cost (%)
 Held to Held Five
 Maturity Years

1. Fixed-Rates Go Down From 10% at

Origination to 9.5%* 10.41% 10.44%

2. Fixed Rates Remain

Constant at 10% 10.85% 10.82%

3. Fixed Rates Go Up From 10% at Origination to

10.50% 11.29% 11.19% * The fixed rate at conversion is FNMA 60-day delivery quote plus 5/8%. The FNMA rate is assumed to be current market rate plus 1/4%.

If the rate on FRMs had remained constant over the first year, the effective cost with conversion would be 10.85 percent with the loan held to maturity and 10.82 percent with the loan held for five years. If rates on FRMs had increased from 10 percent to 10.50 percent during the first year, the effective cost would be 11.29 percent and 11.19 percent for the two respective holding periods.

Note that the effective cost does not vary significantly with a change in the holding period, thus the CARM would seem to be not as sensitive to changes in the holding period as other financing options. Observe also that the effective cost decreases with the shortening of the holding period. This is atypical because the effective cost is usually inversely related to the holding period.

Implications for lenders

Here, we've examined the effective cost of various financing options available to the mortgage borrower. The particular focus was to compare the cost of convertible adjustable rate mortgages to fixed-rate loans and standard adjustable rate loans. Using actual quoted rates for the period November 1988 to November 1989, effective costs for the financing options were calculated under different holding period assumptions. The results show that borrowing cost would have been minimized with a new FRM at the end of year one if the loan was to be held to maturity. If the holding period for the loan was to be only five years, however, this would be the most expensive alternative. With a shortened holding period of five years, the CARM with conversion after one year was the least expensive alternative.

The results reveal some interesting characteristics of the convertible ARM. First, changing the holding period had very little effect on the effective cost of the CARM to the borrower. If the average life of mortgage loans is closer to five years than maturity, the results indicate that lenders would not want to originate CARMs as priced in this example, unless rates on FRMs increased and conversion occured. Secondly, if rates on FRMs remained constant or increased, the effective cost of the CARM increased. Interestingly, however, the cost of the CARM decreased with the holding period. Still, the difference between the cost across the different holding periods was not significant.

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. However, the lender must recognize that conversion shifts all interest rate risk from the borrower to the lender. This means that the lender must ensure that the additional return earned from using CARMs is commensurate with this added risk.

G. Stacy Sirmans is associate professor, department of insurance, real estate, and business law at the College of Business, Florida State University in Tallahassee, Florida.
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Title Annotation:evaluating different loan products
Author:Sirmans, G. Stacy
Publication:Mortgage Banking
Date:Apr 1, 1990
Previous Article:Mandatory home inspections? Is it a structurally sound idea or a proposal lacking a foundation?
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