With a Flat Yield Curve, Which Mortgages Are Best?
October 16, 2006, Revised November 18, 2006, Reviewed September 4, 2009
"Are some types of mortgages priced better for the borrower than others?"
If you qualify for prime lending terms, there isn’t much reason to select an adjustable rate mortgage (ARM) in a flat yield curve market. For most such borrowers, the temporary rate benefit in the early years is too small to justify the risk of higher rates later on.
This is a consequence of what has been referred to as a "flattening of the (bond) yield curve". The yield curve is a graph that shows, at any given time, how the yield varies with the period for which the yield holds. A flat yield curve means that yields on long-term bonds are not much higher than those on short-term notes.
Bond markets affect mortgage markets, and vice versa, because a large part of all new mortgages are converted into mortgage-backed securities (MBSs), which investors view as close substitutes for Government securities and high-quality corporate bonds. Developments in the MBS market, in turn, are immediately reflected in the primary mortgage market where individual borrowers obtain their loans.
When the bond yield curve flattens, the mortgage yield curve facing borrowers flattens as well. This means a marked reduction in the rate differences between FRMs and ARMs. It also means smaller rate differences between FRMs with different terms.
I did my own on-line rate survey on October 8. It covered what loan originators call a "cream-puff" loan – one with no complications. It was a no-cash refinance for $320,000 on a single-family property used as permanent residence and valued at $400,000, to a borrower with good credit who can fully document an adequate income. I used the 30-year fixed-rate mortgage (FRM) as the base, and measured rate differences with other mortgage types when points and other loan fees were the same.
The most interesting result was that the rate on the 30-year FRM was only .25% higher than that on a 3/1 ARM - for example, 6.0% as compared to 5.75%. The lower rate on this ARM holds for 3 years, after which it is adjusted on an annual schedule.
More likely than not, the rate on this ARM will increase at the first adjustment. The new rate will be the value of the rate index at that time plus a margin which remains the same over the life of the loan. We don’t know what the index will be in 3 years, but we know that right now it is about 5.25%, and a competitive margin is about 2.25%. This means that if the market doesn’t change over the next 3 years, the new rate on the ARM will be about 7.5%. A .25% rate difference for 3 years hardly seems like adequate compensation for the additional risk.
Since the 3/1 ARM is not a good choice, the same conclusion holds for 5/1, 7/1 and 10/1 ARMs on which the initial rates hold for 5, 7 and 10 years, respectively. The rate advantage over the 30-year FRM, if any, is smaller than .25%.
Among FRMs with different terms, rate differences are much smaller than in years past. 15-year and 10-year FRMs are priced only about .3% and .4%, respectively, below the rate on a 30-year. The shorter term FRMs remain the better deal, but the reward for borrowers who can afford the higher payments is smaller than it used to be.
The 40-year FRM, in contrast, is priced at about .4% above the 30 and is a poor deal. Borrowers who need a payment below the one on a standard 30-year would do better with the interest-only version of the 30. It is priced only about .1% above the standard 30 and carries a lower payment than the 40.
These observations don’t apply to sub-prime borrowers, most of whom will continue to obtain ARMs because they will be offered nothing else. The most common sub-prime ARM is the 2/1 (the initial rate holds for 2 years), which will typically have margins of 5% or more and carry a penalty for early prepayment.
Another category of borrowers unaffected by recent market changes are those fixated on getting the lowest initial payments available in the market. They will continue to select option ARMs on which the payments don’t cover the interest in the early years. Option ARMs carry margins 1-1.5% above those on other ARMs because lenders view the default risk as higher.
Of course, what to the lender is a high risk of default and loss, to the borrower is a high risk of losing the house. Most borrowers who take option ARMs make the minimum payment, which leads inevitably to payment increases down the road that may be too large for the borrower to handle. (For more, see my Tutorial on Option ARMs ).
"Are some types of mortgages priced better for the borrower than others?"
If you qualify for prime lending terms, there isn’t much reason to select an adjustable rate mortgage (ARM) in a flat yield curve market. For most such borrowers, the temporary rate benefit in the early years is too small to justify the risk of higher rates later on.
A Flat Yield Curve And Its Consequences
This is a consequence of what has been referred to as a "flattening of the (bond) yield curve". The yield curve is a graph that shows, at any given time, how the yield varies with the period for which the yield holds. A flat yield curve means that yields on long-term bonds are not much higher than those on short-term notes.
Bond markets affect mortgage markets, and vice versa, because a large part of all new mortgages are converted into mortgage-backed securities (MBSs), which investors view as close substitutes for Government securities and high-quality corporate bonds. Developments in the MBS market, in turn, are immediately reflected in the primary mortgage market where individual borrowers obtain their loans.
When the bond yield curve flattens, the mortgage yield curve facing borrowers flattens as well. This means a marked reduction in the rate differences between FRMs and ARMs. It also means smaller rate differences between FRMs with different terms.
Rate Survey on October 8, 2006
I did my own on-line rate survey on October 8. It covered what loan originators call a "cream-puff" loan – one with no complications. It was a no-cash refinance for $320,000 on a single-family property used as permanent residence and valued at $400,000, to a borrower with good credit who can fully document an adequate income. I used the 30-year fixed-rate mortgage (FRM) as the base, and measured rate differences with other mortgage types when points and other loan fees were the same.
ARMs Are Not Good Buys
The most interesting result was that the rate on the 30-year FRM was only .25% higher than that on a 3/1 ARM - for example, 6.0% as compared to 5.75%. The lower rate on this ARM holds for 3 years, after which it is adjusted on an annual schedule.
More likely than not, the rate on this ARM will increase at the first adjustment. The new rate will be the value of the rate index at that time plus a margin which remains the same over the life of the loan. We don’t know what the index will be in 3 years, but we know that right now it is about 5.25%, and a competitive margin is about 2.25%. This means that if the market doesn’t change over the next 3 years, the new rate on the ARM will be about 7.5%. A .25% rate difference for 3 years hardly seems like adequate compensation for the additional risk.
Since the 3/1 ARM is not a good choice, the same conclusion holds for 5/1, 7/1 and 10/1 ARMs on which the initial rates hold for 5, 7 and 10 years, respectively. The rate advantage over the 30-year FRM, if any, is smaller than .25%.
Rate Differences Among FRMs Are Small
Among FRMs with different terms, rate differences are much smaller than in years past. 15-year and 10-year FRMs are priced only about .3% and .4%, respectively, below the rate on a 30-year. The shorter term FRMs remain the better deal, but the reward for borrowers who can afford the higher payments is smaller than it used to be.
The 40-Year FRM Is a Poor Buy
The 40-year FRM, in contrast, is priced at about .4% above the 30 and is a poor deal. Borrowers who need a payment below the one on a standard 30-year would do better with the interest-only version of the 30. It is priced only about .1% above the standard 30 and carries a lower payment than the 40.
The Findings Don't Apply to Sub-Prime Borrowers
These observations don’t apply to sub-prime borrowers, most of whom will continue to obtain ARMs because they will be offered nothing else. The most common sub-prime ARM is the 2/1 (the initial rate holds for 2 years), which will typically have margins of 5% or more and carry a penalty for early prepayment.
The Findings Don't Apply to Payment-Myopic Borrowers
Another category of borrowers unaffected by recent market changes are those fixated on getting the lowest initial payments available in the market. They will continue to select option ARMs on which the payments don’t cover the interest in the early years. Option ARMs carry margins 1-1.5% above those on other ARMs because lenders view the default risk as higher.
Of course, what to the lender is a high risk of default and loss, to the borrower is a high risk of losing the house. Most borrowers who take option ARMs make the minimum payment, which leads inevitably to payment increases down the road that may be too large for the borrower to handle. (For more, see my Tutorial on Option ARMs ).
