The Virtues of Variable Rate Mortgages
A run-in with the government has rattled Hudson City Bancorp — and Ronald Hermance's outlook on its bread-and-butter product: 30-year-fixed rate mortgages.March 29
News that Hudson City Bancorp Inc. expects an informal warning from regulators to rein in its interest rate risk sent the Paramus, N.J. thrift's shares tumbling, while validating some mounting concerns about one of the darlings of the post-recession banking industry.March 2
Bankers cannot wait for interest rates to start rising before deciding how they plan to handle it, regulators, executives and others said Friday at a conference devoted to interest rate risk.January 29
Fixed rate mortgages are far more popular than adjustable rate mortgages in the first-lien residential market, capturing a 95% share in the latest Mortgage Bankers Association survey. Fixed-rate loans offer borrowers predictable monthly payments, plus the option to refinance, leaving the lender to bear all of the interest rate and prepayment risk. While banks can offload the risks of these mortgages through securitization, Fannie Mae and Freddie Mac recently hiked annual fees by 10 basis points as part of payroll tax cut legislation, with more increases likely. Is there an alternative mortgage structure that reduces interest rate risk to lenders, but is still reasonably attractive to borrowers?
A variable rate mortgage, offered by major Canadian banks, might be the answer.
Like the ARMs we are familiar with in the U.S., the interest rate on a VRM varies over time, equal to a market index plus a margin. But the payment on a VRM is much more predictable than on an ARM. Generally, the monthly bill stays the same. If the market index and hence the loan interest rate increases, more of each payment is applied to interest and less to principal. Lower market interest rates have the opposite effect. A VRM does not have a contractually fixed amortization period, but instead has a target or planned amortization period. Higher interest rates have the effect of increasing the ultimate term of the loan.
Canadian VRMs have a balloon structure, with a three- to five-year term and a longer planned amortization period, such as 25 years. In addition, monthly payments can eventually increase if the original payment is insufficient to cover the interest on the remaining principal. Thus, borrowers bear all the interest rate risk.
An Americanized VRM might eliminate the balloon structure, and set a target term of 15 or 30 years. The one-year Treasury could serve as the index, with annual rate resets. In addition, as a consumer protection, the monthly payment could be contractually fixed, with no negative amortization permitted. This latter feature would effectively set a monthly interest rate cap, equal to the fixed monthly payment divided by the beginning-of-month principal. Without a fixed term and with an interest rate cap, VRMs would need to be non-assumable, to protect against the risk of a "permanent" below-market loan in a sustained high interest rate environment.
What is the genius of the VRM? First, it solves the vexing trade-off between monthly payment risk and interest rate risk. Lenders (and their regulators) dislike the interest rate risk of fixed-rate mortgages, and borrowers dislike the monthly payment risk of ARMs.
Second, for a VRM with contractually fixed payments and no negative amortization, the effective interest rate cap increases as principal is repaid. This makes sense, because as their equity in the property rises, the borrower has increased capacity to bear interest rate risk.
This innovation from our Canuck neighbors deserves a close look here south of the border.
James B. Wiggins is an Associate Professor of Finance at Michigan State University in East Lansing.