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ADJUSTABLE RATE MORTGAGE.
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Definition, role in residential lending, interest rates, innovations, termination rates. Tables.... More...
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Paper Abstract:
Definition, role in residential lending, interest rates, innovations, termination rates. Tables.
Paper Introduction:
A SPECIFIC INNOVATION IN THE MORTGAGE MARKET: THE ADJUSTABLE RATE MORTGAGE
Introduction
Residential real estate mortgages are issued in a variety of types, as well as for a variety of terms near the end of the decade of the 1990s. The scope in mortgage types and terms, however, was not always the case in the United States. Financing innovations over the past two decades have changed the face of the residential real estate mortgage market (Szerb, 1996). This research examines one innovation in residential mortgage lending—the adjustable rate mortgage (ARM).
Defining An ARM
In the contemporary period, the most prevalent residential mortgage types the are fixed-term/fixed rate mortgage and the A
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4 ). 3 [Herzog & Laverty, 1995] Vanderhoff (1996) found that ARMs were prepaid less frequently thanwere either 3 -year, fixed rate mortgages or 15-year, fixed-rate mortgageswhen interest rate levels declined. 4 ). 6 . .26 .55Streamlined RB MIP . With COFI ARMs, the mortgage's monthly payments arerecast every five years or at any point at which the loan amount reaches125 percent of the amount of the original mortgage" (Cotton, 1995, p. 8Special LTV 8.69 7.57 2.99 2.17 1. . The impact of initial-year discounts on ARM prepayments. These findings were based on data for the 1983-1996period.Table 4Cumulative Claim Termination Rates (%) Through 31 December 1993 For ARMs________________________________________________________________ ___Calendar Year of Origination____ 1988 1989 199 1991 1992All Section 2 3 (b) 6.54 5.11 1.92 .7 .15All Nonrefinancings 6.54 5. 7.38 1.34Special LTV 44.79 45.95 44.65 11.97 9.16 25. . 2Special LTV 1.56 1.62 1.11 .38 . 41). The COFI is "attractive to borrowers in a rising interest rateenvironment since the index lags some other common indexes" (Cotton, 1995,p. 5All Nonrefinancings 2.55 1.74 1.19 .57 .12Nonstreamlined 2.31 1.6 .96 .17 . . A white paper on FHArefinancings. Defining An ARM In the contemporary period, the most prevalent residential mortgagetypes the are fixed-term/fixed rate mortgage and the ARM. .16 . Many borrowers select a 15-year termwhen they refinance in order to take advantage of even lower interest rateson these shorter-term mortgages and to pay off their mortgage before theyretire or before their children enter college. The Role of ARMs in Residential Mortgage Lending ARMs accounted for approximately 4 percent of all home loans in 1995(Cotton, 1995). 14.29 37.5 32.19 15.22 1.83Streamlined RB MIP . . Borrowers also may choose "rate-capped and payment-capped ARMs, loans that eliminate closing costs paid bythe borrower and mortgages with indexes that lag the more traditionalTreasury index" (Cotton, 1995, p. K., & Shilling, J. 4% 9.85%199 9.76% 8.46% 9.63%1991 9.27% 7.13% 9. 8 3.96 .72All Nonrefinancings 33.76 31.16 17.16 7.81 3.19 .52Nonstreamlined 18.18 36.36 33.33 14.6 6.49 1.29Streamlined Non-RB . "Six-month LIBORARMs frequently offer lower initial interest rates, life caps and marginsthan other ARM products. 42). This research examines one innovation in residential mortgagelending-the adjustable rate mortgage (ARM). At theend of each 12-months, however, the interest rate may be adjusted by thelender in accordance with the mortgage contract. Some mortgage lenders offer borrowers an option of a discountedinterest rate in "exchange for a penalty if the loan is paid off early.Typically, borrowers who choose to accept the prepayment penalty receiveeither a discounted interest rate, or a waiver of closing costs, a popularoption with first-time home buyers. Vanderhoff, J. 3 43.83 42.67 3 .95 1 .55 1.78All Nonrefinancings 44.51 43.39 42.22 26.69 7.22 .83Nonstreamlined 62.44 68.19 68.67 5 .92 1 .62 1.7 Streamlined Non-RB 44.44 68. (1996, May). 2All Refinancings 1 .12 5.73 3.42 1.6 .17 [Herzog & Laverty, 1995]________________________________________________________________________________________________________________________________Table 3Cumulative Claim Termination Rates (%) Through 31 December 1993 For 15-Year, Fixed-Rate Mortgages________________________________________________________________ ___Calendar Year of Origination____ 1988 1989 199 1991 1992All Section 2 3 (b) 2.53 1.73 1.18 .44 . While claim terminations for ARMs are slightly higher than for either3 -year, fixed-rate mortgages or 15-year, fixed-rate mortgages, otherstudies have found that non-claim termination (paying off a mortgage) ratesare somewhat higher for ARMs than for either 3 -year, fixed-rate mortgagesor 15-year, fixed-rate mortgages. E. 5 . 8.33 .48 .14Streamlined Non-RB . 1.19 1.2 .35Streamlined RB MIP . 55.63 36. 7 2 .98 3.15 [Herzog & Laverty, 1995]________________________________________________________________________________________________________________________________Table 6Cumulative Nonclaim Termination Rates (%) Through 31 December 1993 For 15-Year, Fixed-Rate________________________________________________________________ Calendar Year of Origination_________ 1988 1989 199 1991 1992 1993All Section 2 3 (b) 38.6 38.57 36.62 25.65 8.15 1.22All Nonrefinancings 37.94 38.12 35.85 23.71 5.78 .65Nonstreamlined 5 .14 46.52 48.76 3 .21 7.66 .75Streamlined Non-RB . Payment-capped adjustable-ratemortgages, "the most popular of which is based on the 11th Federal HomeLoan Bank System District Cost-of-Funds Index (COFI), offer caps on theborrower's monthly mortgage payment" (Cotton, 1995, p. Non-claim termination rates for ARMs where initial year interest ratesare provided by mortgage lenders have been found to be approximately thesame as for ARMs where initial year discount rates are not provided (Green& Shilling, 1997). . 3 .77 1 .55 8.71 1.67 [Herzog & Laverty, 1995]________________________________________________________________ References Cotton, J. The number of ARMsoriginated increased from 21,776 mortgages in 199 to nearly 1 6, in1993.Table 1Average Contract Interest Rate________________________________________________________________Year Type of Mortgage_________________ 3 -Year Term Adjustable Rate 15-Year Term Fixed Rate Mortgage Fixed Rate1984 12.87% 12.39% 12.13%1985 11.88% 9.64% 11.41%1986 9.79% 8.84% 9.59%1987 9.35% 8.19% 9. . With the LIBOR index, borrowers also can avoidextreme payment fluctuations since interest rate adjustments typically arecapped at one-percent every six months" (Cotton, 1995, p. In thisscenario, the "shortfall between the required interest payment and themonthly mortgage payment is added back into the loan balance in the form ofnegative amortization. Shaffer, R. . Borrowers who expect to remainin their homes at least three years, or who need money for closing costsare most likely to take advantage of this option. Typically, these caps limitthe interest rate increase in each adjustment period to no more than two-percent, with a lifetime cap of six-percent above the interest rate chargedat the inception of the ARM. 9 . 7 1.33 .18All Non refinancings 6.1 4.3 3. 26.29 24. 9%1993 7.79% 5.84% 7.45% [Herzog & Laverty, 1995]________________________________________________________________ For each calendar year of origination during this period, theproportion of 15-year-term loans that were refinancings was greater thanthe proportion of 3 -year-term loans that were refinancings (Herzog &Laverty, 1995). A Specific Innovation in the Mortgage Market: The Adjustable Rate Mortgage Introduction Residential real estate mortgages are issued in a variety of types, aswell as for a variety of terms near the end of the decade of the 199 s.The scope in mortgage types and terms, however, was not always the case inthe United States. Farewell to ARMs: Why fixed-ratemortgages are still your best bet these days. This indexrepresents the average cost of borrowing for member institutions of the11th District of the Federal Home Loan Bank System and is determined bydividing the members banks' interest expenses in a given month by theirtotal outstanding debt. Further Innovations in the ARM Concept As the demand for ARMs has increased, mortgage lenders have developedfurther innovations in the product (Cotton, 1995). . Interest rate caps provide borrowers the"security of knowing their payments will not climb above a certainpredetermined point at each adjustment period or over the life of the loan. 42). 6.76 1.73Special LTV 5 . Borrower demand for ARMscontinued into and through 1996. For borrowers seekinglow initial monthly mortgage payments as an alternatives to fixed-ratemortgages, lenders now offer a range of adjustable-rate mortgages with avariety of indexes, margins, caps, reset periods, and conversion options."While the 1/1 and 3/1 Treasury-indexed ARMs" remain popular withborrowers, ARMs in the contemporary period may be customized to meet theneeds of specific borrowers (Cotton, 1995, p. Some states, however,restrict or prohibit prepayment penalties. . When the interest rate increases rapidly to the fully indexedrate, however, the borrower's monthly payment typically is not sufficientto cover the monthly interest expense on the mortgage contract. Real Estate Economics, 24(3 , 379-4 6. Comparisons of non-claim terminationrates for the three types of mortgages are presented in Tables 5 through 7.Table 2Cumulative Claim Termination Rates (%) Through 31 December 12993 For 3 -Year, Fixed-Rate Mortgages________________________________________________________________ ___Calendar Year of Origination____ 1988 1989 199 1991 1992All Section 2 3 (b) 6.22 4.33 3. Borrowers in New York, Florida,Massachusetts, Iowa and California are among those who can choose the pre-payment penalty option when selecting their mortgages" (Cotton, 1995, p.41). (1995, February). . 8 4.91Streamlined RB MIP . The borrower's choice of fixed and adjustable ratemortgages in the presence of nominal and real shocks. N., & Laverty, J. 5 2. 5%1992 8.4 % 6.3 % 8. 42). 33.33 19.2 3. Financial World, 166(9), 71-73.Szerb, L. As an example, a3 -year fixed-rate mortgage loan provides for repayment of the loanprincipal over 36 months at a fixed-rate of interest over the life of theloan. The interest rate isadjusted in accordance with movements in an index that is specified in themortgage contract, such as the prime interest rate, which is named in themortgage agreement. 6 1.29 .18Non streamlined 1 .2 5.46 3.53 1.17 .16Streamlined Non-RB 33.33 . Borrowers also may obtain ARMs which offer a semiannual rate-cappedLondon Interbank Offered Rate (LIBOR) (Cotton, 1995). . The lender's prepayment penaltyusually is set as either a percentage of the outstanding mortgage balance,or one or two additional monthly payments. . Interest rates on ARMs typically are lower than those on long-termfixed-rate mortgages, because the lender assumes a lower risk by committingto a specific interest rate for a shorter time period with respect to ARMs. Dhillon, U., Saaadu, J., & Shilling, J. . ARM contract typically offer the borrower "some protection frominterest rate shocks in the form of rate or payment caps" (Cotton, 1995, p.4 ). Streamlined RB MIP . . All Refinancings 49.47 46.26 47.87 29.39 8.87 1.3 [Herzog & Laverty, 1995]________________________________________________________________Table 7Cumulative Nonclaim Termination Rates (%) Through 31 December 1993 For ARMs________________________________________________________________ Calendar Year of Origination_________ 1988 1989 199 1991 1992 1993All Section 2 3 (b) 33.73 31.14 17.21 8. . 3%1988 1 .11% 8.86% 9.8 %1989 9.94% 9. All Refinancings 2.22 1.59 .97 .18 . (1995, May). (1997, Fall). The first was atapering-off of residential mortgage refinancing boom, while the second wasan increase in the originations of ARMs. The claimtermination rates for the three types of residential mortgages for loansoriginated during the 1988-1992 inclusive period are presented in Tables 2through 4. Real Estate Economics, 25(3), 373-385. 41). (1996). Mortgage Banking,55(8), 38-43. D. Mortgage Banking, 55(5), 5 -57. Further, borrowers who do not plan to live in the home more than a fewyears benefit from the lower initial interest rate with an ARM product, andthey may still have a rate advantage over fixed-rate even after the firstadjustment period" (Cotton, 1995, p. . D. The assumption is that mostARMs originated in 1992 and 1993 were loans to first-time home buyers whowere able to qualify for a larger loan with an ARM and its lower interestrate than with a fixed-rate mortgage. Claim Termination Experience Claim terminations tend to be higher for ARMs than for either 3 -year,fixed-rate mortgages or for 15-year, fixed-rate mortgages. Armed for competition. Mortgage interest rates for 3 -year,fixed-rate mortgages, 15-year, fixed-rate mortgages, and ARMs are comparedin Table 1, which may be found on the following page. 6.57 5.61 16.67All Refinancings 23. 7Streamlined RB MIP . Journal of Real EstateFinance and Economics, 12(3), 265-277. 2Special LTV 49.19 52.13 55.48 24.52 9.35 5 . . 41). (1996, Fall). Adjustable and fixed rate mortgagetermination, option values, and local market conditions: An empiricalanalysis. Choosingbetween fixed- and adjustable-rate mortgages. . 5 . . A one-year variable-rate innovative ARM loan, by contrast, may bestructured so that it is renewable each year for a 3 -year period. . Although the monthly or semiannual adjustments tothe mortgage's interest rate are not capped, the borrower's payments areadjusted annually and are limited to an annual increase or decrease of 7.5percent. The proportion of 3 -year, fixed-rate loans used forrefinancing is, in turn, greater than the proportion of ARMs that wererefinancings for each calendar year. . 7 1.91 .66 .15Nonstreamlined 9. . 4Streamlined Non-RB . 9 66.35 41. . Thus, borrower demandhas increased for 5/1, 7/1 and 1 /1 Treasury-indexed ARMs, which offer"stable monthly payments for five, seven or 1 years and fixed-rateconversion options" (Cotton, 1995, p. Most ARMs contain a capping clause, which limits theamount of the interest rate increase which may be made at the end of anysingle 12-month period (Dhillon, Saaadu, & Shilling, 1996). While the number of 3 -year, fixed-rate mortgages originated annuallyremained in a relatively narrow range from 528, to 64 , during the1988-1993 period, the number of reported non refinancings declined from apeak of 627,165 mortgages in 199 to only 338, 1 mortgages in 1993 (Herzog& Laverty, 1995). At times, however, it is theoretically possible for short-term conditionsto cause rates on ARMs to be higher than those on long-term fixed-ratemortgages (Shaffer, 1997). Real EstateEconomics, 24(1), 43-54. The increase in mortgage interest rates in 1995 spurredtwo important trends in the residential mortgage market. 7Special LTV . All Refinancings 61.65 66. Such interest rate caps impose both periodic and lifetime ceilings onthe interest rate of the underlying mortgage. Herzog, T. 8 25. During such periods, ARMs also weremore likely to be defaulted than either version of the fixed-ratemortgages. . Financing innovations over the past two decades havechanged the face of the residential real estate mortgage market (Szerb,1996). . 1.47 .91All Refinancings 7.69 18.75 7.69 1.11 .19 [Herzog & Laverty, 1995]Table 5Cumulative Nonclaim Termination Rates (%) Through 31 December 1993 For 3 -Year, Fixed-Rate Mortgages________________________________________________________________ Calendar Year of Origination_________ 1988 1989 199 1991 1992 1993All Section 2 3 (b) 45. (1997, November). . . At the same time, the number 15-year-term mortgageoriginations rose from fewer than 3 , mortgages in 199 to more than1 , in 1993, as mortgage interest rates fell. . Green, R.
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