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Adjustable Rate Mortgages on the Rise


About 60% of U.S. homeowners have a mortgage and most have a mortgage that lasts 30 years with a fixed interest rate. Monthly payments to the bank do not change over the life of those loans.

From early 2020 through early 2022, adjustable-rate loans made up less than 5% of all mortgage applications, according to the Mortgage Bankers Association, a nonprofit organization representing the U.S. mortgage finance industry.

But by mid-2022, they made up more than 10% of mortgage applications, a level unseen in over a decade. For the last full week of October, nearly 12% of mortgage applications were for adjustable-rate loans. The last time they were notably popular was during the run-up to the housing collapse that sparked the Great Recession of the late 2000s. Adjustable-rate mortgages made up over a third of mortgage applications each year from 2004 to 2007 before plummeting to less than 5% across parts of 2008 and 2009 and remaining under 10% until recently.

The United States (U.S.) is the only country in the world in which the 30-year fixed-rate residential mortgage is the dominant home mortgage product. After reviewing mortgage offerings from a sample of countries to contrast their differences from the U.S. mortgage market, the key differential driving the U.S. market to the 30-year fixed rate mortgage is the active encouragement by government policy. This reinforcing promotion of the 30-year fixed rate mortgage is provided by the government and “quasi” government institutions that guarantee the mortgage in the after-market. This guarantee coupled with the vast securitization of mortgages which require a standardization of the underlying product (of which the 30-year fixed rate mortgage is the largest sector) contributes to this dominance.

Thus securitization, which allows lenders to offset interest rate and prepayment risks to the buyers of these securitized mortgage products, further drives the demand for more 30-year fixed rate offerings.

Those attempting to buy a home have a number of financing options available to them depending on their credit standing. They could buy the home outright, but this is rarely an option. Sometimes this is possible when a home is sold and the sellers are looking to downsize and purchase a smaller less expensive home.

But the typical route to homeownership is that the potential buyer secures a mortgage that includes an equity stake (i.e., the down payment). The greater the down payment (i.e., the bigger the equity position taken on by the buyer and thus the greater the amount of risk assumed), the lower the interest rate attached to the mortgage. The most frequent down payment in the U.S. market without the additional requirement of having to pay mortgage insurance to protect the lender is 20%.1 Not only do mortgage options differ from state to state but there are vast differences among developed countries. In the U.S. mortgage marketplace, the dominant residential mortgage is the 30-year fixed rate mortgage (FRM), which is not consistent with the rest of the world.

For example, a 30-year 6% fixed rate $200,000 mortgage locks in a monthly payment (principal and interest) of $1,199.10 over the life of the mortgage. Even though both the mortgage payment and interest rate are fixed, the amount applied to interest and principal changes each month with the interest portion decreasing and the principal portion increasing.2 For instance, the amounts going towards principal and interest during the 24th month are $223.30 and $975.80, respectively. But during the 24th month, the corresponding values are $655.79 and $543.31. A variable rate mortgage needs the adjustment process defined before the mortgage can be written. For illustration in a 3/1 ARM with a 30-year term, the interest rate is fixed for the first three years and then adjusts annually for the remaining 27 years. This initial rate is typically lower than the fixed rate offered at the same time to compensate for the added interest rate risk taken on by the borrower. Thereafter, the rate will be determined at some benchmark index rate plus a fixed premium. For instance, if the ARM is defined as the prime rate plus 150 BP (basis points) adjusted annually, the new rate after the initial 3 years will be 6.5% if the prime is 5%. The base and the adjustment factor can be defined around any benchmark, such as London Interbank Offered Rate (LIBOR),3 1-year constant Treasury (CMT), and Euro Interbank Offered Rate (Euribor).

Also, a CAP (maximum value) and a FLOOR (minimum value) for the interest rate (both annually and lifetime) could be attached to the terms of the mortgage offer. On the $200,000 3/1 ARM offered at 5%, the monthly payment during the first three years would be $1,073.64, a savings of $125.46 versus the 6% fixed rate offers. The interest rate adjustments in the future will dictate which option (fixed versus variable) was the better choice. Most home buyers prefer the fixed rate option, especially in low-interest rate environments, because it eliminates interest rate risk and is, therefore, willing to pay the initial interest differential.

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