Question

Suppose that you are thinking about taking out an adjustable rate loan (ARM) with the following information:

       

       Teaser Rate: 3.5%

       Margin: 4.0%

       Year 1 TSY Strip Index: 2.0%

Year 2 TSY Strip Index: 3.5%

Year 3 TSY Strip Index: 1.5%

Periodic Cap: 1.0%

Lifetime Cap: 5.0%

Caps are NOT based off of the Teaser

A)What is the interest rate in the 1^st year of the loan?

1. 3.5%
2. 5.5%
3. 6.0%
4. 7.5%
5. None of the above

6. B)What is the interest rate in the 2^nd year of the loan?

7. 3.5%
8. 4.0%
9. 6.0%
10. 7.0%
11. None of the above

12. C)What is the maximum possible interest rate you will pay throughout the life of the loan?

13. 8.5%
14. 9.0%
15. 11.0%
16. 12.5%
17. None of the above

Answer 1

a)
The interest rate in the first year of the loan will be equal to the teaser rate = 3.5%, even though the rate as per the margin and 1 year strip rate should be = 6%

b)
The interest rate in the first year of the loan should be = Year 2 strip index plus margin which will come 7.5%. Since we are given that the caps are not based off of the teaser rate, the periodic rate cap of 1% will would be on the possible Year 1 rate if teaser was not there i.e. 6% . Hence Year rate stands capped at 7%

(c) Given the lifetime cap of 5% but since it is not based off of the teaser, then like above it should be linked to Year 1 possible rate. This will mean that the maximum rate possible during the life is going to be 11%.

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