Question

it is very important that you show your work from the calculations (right down what you used as PV, i FV, n, cash flows,.....etc. in your calculation)

Matt and Jane are in the market for mortgage. Matt expects to prepay his loan in 4 years while Jane expects to hold her loan for 15 years. Ceteris paribus (everything else being the same), which of the two, Matt or Jane, is more likely to choose an ARM over an FRM? Briefly explain why.

Answer 1

Here, will check that Mate and Jane are planning to keep their Mortgage loans for Certain time periods only, however Mate is expected to prepay his loan in 4 years only and Jane is looking to continue the loan for 15 years, now will understand the ARM and FRM difference for how to select, which Rate for which time horizon.

ARM should generally used for

How large a mortgage payment can you afford today?

If rates will rise could you still afford the same?

How long do you intend to live on the property?

In current market in what direction the interest rates are moving?

Basis on the need of one should always choose that which suits them best.

If a person looking to prepay the loan amount in short time then they should always choose the ARM method reason for choosing the same is that ARM is always cheaper than that of FRM because of flexible in nature and one get take a benefit by picking up the ARM by thinking short term payment in loan account.

Now, will see the FRM method for the loan repayment as this is the best method for those who are keen to make payment till the end of the loan periods as the payment will be for a longer period one cannot be sure of the market and of the economy where it will go, however by picking the FRM one can be assure of paying the fixed interest only for the whole life of the loan.

So here the preference for choosing the rate method will be

For Matt will choose the ARM where he is thinking of prepaying the loan in 4 years hence this will benefit Matt in terms of saving the interest on the calculation of the 4 years till the whole prepayment.

For Jane we will go for FRM because he is thinking to keep his loan alive till the end of the loan tenure, so this will benefit him because it will be long tenure and within that span of time the market change and the economy change will affect the rate by choosing the FRM one can be assure of the rate change in his loan account and the payment of interest will be fixed.

In short when the person is looking the prepay the loan in short period then he must have to accept ARM method

And while the loan will end at the end of the loan tenure then he must have opt the FRM so as to be safe with the market change.