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   ARTICLE   |   From Scotsman Guide Residential Edition   |   July 2017

Carry ARMs in Your Quiver

Adjustable-rate mortgages are a valuable weapon against rising rates

arms 7-17Disruption, the trendy phrase in the fintech world, describes the expected impact of new web-based technologies on current lending practices in fundamental ways. Mortgage originators experienced another type of disruption this past November when interest rates jumped above 4 percent for the first time in almost two years, spoiling the cozy world of endless refinancing in a historically low interest rate environment.

Many originators neglected to cultivate the purchase market because of the easier pickings of low-hanging refi fruit. The unending growth they had come to expect was steamrolled by rate hikes, replaced by slim application volumes and thinning pipelines.

Increasing tensions from decreasing production numbers and increasing fixed costs were alleviated slightly by refi stragglers, while recent dips in interest rates provided some relief in the form of cash-out refis. With interest rates forecasted to continue rising, however, it will become harder and harder to convince borrowers to refinance at a higher rate than their current mortgage, even to tap into their home’s equity.

Understanding ARMs

Mortgage originators excel at finding products that help people purchase their dream home, which is what the mortgage business is all about. One product that meets many niche needs is the hybrid adjustable-rate mortgage, or ARM, which was introduced in the early 1990s by a large West Coast bank to make high-priced California homes affordable.

It also is important for mortgage originators to understand refinancing patterns when considering how to market ARM products.

A hybrid ARM shortens the duration of a 30-year fixed-rate loan by creating a loan with a fixed initial period of three, five, seven or 10 years and a reset to an annual or semi-annual adjuster based on a short-term index such as the six- or 12-month Libor.

The shorter duration allows the loan to be priced lower over the front end of the curve, so it is the yield curve that determines the viability of these loans. A flat or inverse curve makes them uncompetitive, while a steep curve makes them more viable.

If the federal funds rate is at 1 percent and 10-year Treasury rate is 2.25 percent, for example, the 30-year fixed rate will likely be 3.875 percent, while a 5/1 ARM would be around 2.875 percent. Many borrowers will accept the additional 1 percent interest for the certainty of a — still historically — low rate for the duration of their loan.

Now let’s assume the Fed continues its tightening regime — which seems likely over the next few years — and the federal funds rate goes to 1.50 percent. Increased uncertainty tends to steepen the curve, so the 10-year Treasury rate goes to 3.5 percent. At this point, short-term spreads will tend to stay put while longer-term spreads will widen. So in this environment, the 30-year fixed rate could increase to 5.75 percent, while the 5/1 ARM rate might only rise to 3.375 percent, making it far more attractive.

No originator needs to be told that ARMs are a great choice for their borrowers when rate spreads get this far apart. In general, the higher fixed mortgage rates get, the better ARMs look to borrowers concerned with affordability, which explains why the market share of ARMs often exceeded 40 percent in California in the 1990s and hit 25 percent nationwide before the crisis. Today, ARMs account for only around 10 percent of total origination volume.

Marketing ARMs

Affordability was the initial driver for ARM products back in their heyday, and these loans are still particularly well-tuned to the jumbo market. The reason is clear: savings.

Using the hypothetical interest rates described earlier, a borrower who takes out a $900,000 loan in the low-rate scenario will have a monthly payment of $4,232 on a 30-year fixed and $3,734 on the 5/1 ARM, a difference of $498. In the higher-rate scenario, where the yield curve steepens, the 30-year fixed-rate borrower pays $5,252 monthly while the 5/1 ARM borrowers pays $3,979. This is a difference of $1,273, or an annual saving of more than $15,000. The homebuyer using a hybrid ARM loan, because of its favorable front-end pricing structure in a rising-rate environment, can afford a lot more home than the 30-year fixed-rate borrower.

It is fairly easy to sell the savings advantages of ARMs for jumbo loans, especially as interest rates rise, but purchase-market originators need to understand the other areas where ARM loans make sense. This will allow them to better align their marketing to the proper purchase-borrower segments. First and foremost, it is important to make Realtors understand that marginally-qualified borrowers can be-come homeowners with an ARM loan’s lower fixed-rate period rate, which provides affordable payments.

Another target group are borrowers with an expected, well-defined, short period of residing in the home. ARMs are a particularly good fit for corporate-relocation clients who typically get moved again by their companies after three to five years. They will have less concern about a reset in a higher interest rate environment, and they will enjoy the lower monthly payments over the front end of the loan while they live in that home.

First-time homebuyers are another potential target for ARMs. They tend to lack confidence and understanding of the homebuying process, however, and need the support of experienced loan originators to answer their questions and guide them through the process. Fannie Mae and Freddie Mac only accept fixed-rate loans for their 97 percent HomeReady and Home Possible programs, but 5/1 and longer fixed-period ARMs work well with their 5 percent downpayment products, while ARMS are the obvious choice for borrowers eligible for U.S. Department of Veterans Affairs (VA) programs because of the added savings over what their VA benefits already provide.

Millennials are another highly sought-after population, a group that will be mortgage consumers for the next 40 years. They seem elusive and not in a great hurry to settle down in their own homes, but the reality is that many millennials are highly educated, well informed and quite well paid — often in the form of year-end bonuses. This ready-made downpayment source can help millennials get past the sticker shock of a mortgage, while the affordable, low monthly payments of an ARM mortgage will make budgeting easier for young homeowners saddled with large amounts of student-loan debt.

Refinancing ARMs

Looking beyond purchase loans, originators can take advantage of lower ARM rates to reach a segment of borrowers that otherwise would be outside the shrinking universe of rate-and-term refinanceable loans.

It also is important for mortgage originators to understand refinancing patterns when considering how to market ARM products. In years past, ARM borrowers, concerned about reset rate shock at the end of the fixed period, would refinance into fixed-rate mortgages when those rates got close to the borrower’s ARM rate.

Today’s borrowers seem comfortable with their ability to refinance whenever they need and will even refinance from one ARM to another. Prepayments tend to ramp up steadily during the fixed period, and jump to 35 percent to 45 percent close to the reset date. The last three months before the expiration of the fixed-rate period on an ARM is the time when borrowers have the highest propensity to refinance their loan, which is the perfect time to contact them for a refi.


 


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