Question

18)   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?

3.5%

5.5%

6.0%

7.5%

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

3.5%

4.0%

6.0%

7.0%

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

8.5%

9.0%

11.0%

12.5%

Answer 1

Hello Mam/Sir

(a) The first year rate 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) Year 2 rate 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%.

I hope this clears your query.

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