How A Credit Union Can ARM Against Rate Risk

PenFed’s large stake in unusual adjustable rate mortgages helps defend against rate hikes while bolstering its bottom line.


Pentagon Federal Credit Union ($17.8B, Alexandria, VA) is counting on two unusual adjustable rate mortgage offerings to help defend its bottom line and mobile, military-heavy membership against coming hikes.

The nation’s third-largest credit union is in its seventh year of offering a 5/5 ARM and has added a 15/15 ARM. The 5/5 ARM accounted for more than 40% of the nearly $2 billion in first mortgages PenFed made in 2014, according to Craig Olson, the credit union’s senior vice president of mortgage operations.

That heavy concentration of ARMs helped drive PenFed’s average yield on loans down to 3.58% in fourth quarter 2014, compared with an average of 4.60% in the credit union’s asset-based peer group.


data as of 12.31.14
  • HQ: Alexandria, VA
  • ASSETS: $17.8B
  • MEMBERS: 1,305,552
  • BRANCHES: 30
  • 12-MO SHARE GROWTH: 3.85%
  • 12-MO LOAN GROWTH: 8.97%
  • ROA: 0.80%

Meanwhile, PenFed generated $558.53 million in interest income from loans last year. That’s 81.99% of its total income, compared with 64.16% for its asset-based peer group.

It also grew net income 18.55% in 2014, compared with 5.44% during the year for the other 229 billion-dollar credit unions and 7.53% for all credit unions in the United States, according to Callahan & Associates data.

How It Works

PenFed’s mortgage portfolio increased 22.88% in 2014 compared with 11.49% for the average credit union in the 229-member billion-dollar club. It did that while keeping things simple yet innovative.

“We always want to give our members the best rates we can while providing them choices they think will best fit their individual futures,” Olson says.

The credit union offers four mortgages: 30-year fixed, 30-year jumbo, the 5/5 ARM, and the 15/15 ARM. The 5/5 adjusts no more than two percentage points at each stop, and no more than a total of five during its lifetime. At its current posted APR of 3.252%, that means the rate will never exceed 8.252%.

That option is available for refinancing or home purchases. There is no origination fee and borrowers can lock the rate for 90 days for free. The 15/15 ARM carries a 1% origination fee and borrowers can lock the rate for 60 days. After the loan closes, the rate stays fixed for 180 months. It then can adjust to no more than six percentage points above the initial rate and no lower than a floor rate of 1%.

The 5/5 ARM also comes with something different: a rate reset option. Borrowers can take an initial rate 0.25% higher than the current ARM rate and then reset it five times during the life of the loan. The new rate would be the lesser of adding 2.25% to the Fed’s Current Index or adding 0.25% to the credit union’s 5/5 rate at that point.

Special offers for using the credit union’s in-house real estate agency when possible also sweeten the deal. Currently, the credit union is offering savings of up to $10,000 when members use Berkshire Hathaway Home Services PenFed Realty to buy a home.


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Why It Works

PenFed is an efficient organization. It averages $11.40 million in loan balances for each of its 1,428 employees, nearly four times the average for its peer group. It’s also boasts a loan-to-share ratio of 116.69% as of Dec. 31, 2014. According to Callahan data, PenFed ranks among the top 10 of billion-dollar credit unions in both these metrics.

A respectable efficiency ratio of 62.48% compared with 75.01% for its peer group and an operating expense ratio of 1.31% — among the lowest 10% among big credit unions — also speak to its ability to make the most of its human and technology resources. In fact, its net income per employee of $96,595 in fourth quarter 2014 is nearly twice that of its peer group average.

PenFed spends on par with peers when it comes to marketing per member — $13 per member in fourth quarter 2014 compared with $15 on average for billion-dollar credit unions — but there’s more to it than that.

“We have a little different model than many credit unions do,” Olson says. “We don’t have loan officers out in the field, and the majority of our loan applications come in online.”   That’s a big field. While PenFed does have 30 branches, it has members in all 50 states and at military installations in Guam, Puerto Rico, and Okinawa.

Like starched fatigues, PenFed’s mortgage pages are sharp, unadorned and well-organized, including a landing page for each offering that leads to a sparse, user-friendly application interface.

The credit union also has fine-tuned its ability to raise and lower demand for its mortgages by increasing and decreasing rates slightly, says Kevin Heal, vice president of business development and advisory at Callahan & Associates.

“That’s pretty sophisticated and can only come from years of experience in understanding and adjusting to market realities,” says Heal, a 25-year veteran of the housing finance and securitization industry. “The result has been a long record of success in mortgage lending.”

My crystal ball is broken right now, but I can say we didn’t see fixed rates dropping as low as they did. And we know ARM products become popular as fixed rates rise. 

Indeed, PenFed’s considerable asset base is heavily concentrated in real estate loans: nearly 69% in fourth quarter 2014 compared with 36% on average for its asset-based peer group. And more than half of that $10.38 billion mortgage portfolio is in that 5/5 ARM.

So what about interest rate risk?

Strategic Confidence

Although a higher number of borrowers are currently looking for fixed rates ahead of the expected interest rate hike, that’s not a certainty going forward, Olson says.

“My crystal ball is broken right now, but I can say we didn’t see fixed rates dropping as low as they did,” Olson says. “And we know ARM products become popular as fixed rates rise.”

PenFed’s calculations assume borrowers’ rates will rise to the highest point allowable when the adjustments roll around. And that gives Olson confidence in his credit union’s ability to handle the risk.

“If you’re willing to do that initial interest rate at five years, why not be willing to adjust and do the next interest rate for five years?” he asks. “From an interest rate risk perspective, that second five years is not much different for the credit union than the first.”

That makes sense to Heal.

“Being able to adjust the rates upward on such a large concentration of my mortgages would give me confidence in my portfolio’s ability to deal with rising interest rates, too,” the housing finance consultant says.