Question

David is considering an adjustable rate mortgage loan with the following characteristics: • Loan amount: $250,000 • Term: 30 years • Index: one year T-Bill • Margin: 2% • Periodic cap: 2% • Lifetime cap: none • Negative amortization: not allowed • Financing costs: 1 discount point and $5,500 in origination fees.

The Treasury bill yield is 6% at the outset and is expected to increase to 8% at the beginning of the second year and to 13% at the beginning of the third year. If David prepays the loan at the end of the third year, what is the ARM’s effective borrowing cost?

Answer 1

Given,

Index for 1^st year=6%, second year= 8% and for 3^rd year=13%

Margin= 2%

Periodic cap= 2%Life time cap: None

Interest rates are as follows:

1^st year: 6% + 2% = 8%

2^nd year: 8% + 2% = 10%

3^rd year: 13% + 2% = 15% or previous rate of 10% plus cap of 2% =12% whichever is earlier. Hence, the rate applied is 12%.

Effective borrowing cost= 11.1721%

Calculation as below: