Question

You are looking to finance your home. The bank is offering a three-year ARM (adjustable-rate mortgage) with an introductory rate of 3.40%. It has an adjustment cap of 3.00% per adjustment period with a lifetime adjustment of 8.00%. The rate is 4.00% over the one-year LIBOR rate which is currently 1.25%.

What will your interest rate be after three years if the LIBOR rate does not change? (Round your answer to 2 decimal places.)

In three years, what is the maximum interest rate you could be charged? (Round your answer to 2 decimal places.)

If LIBOR increases 1.00% per year for the next 10 years up to 11.25%, what is the maximum interest rate you will pay? (Round your answer to 2 decimal places.)

When will that rate take effect?

- Ending of year 10

or

- Beginning of year 10

Answer 1

a). If LIBOR rate remains 1.25% then after 3 years, interest rate will be LIBOR + 4% = 1.25%+4% = 5.25%

b). Introductory interest rate is 3.40% and maximum adjustment per period is 3% so maximum interest rate in 3 years can be 3.40% + 3% = 6.40%

c-1). For each ARM period, the interest rate charged is the lowest of the three rates which can be charged:

Year 1-3: Introductory rate = 3.40%

Year 4-6:

1st rate: 4% over LIBOR = 4% + (1.25%+(3*1%)) = 4% + 4.25% = 8.25%

2nd rate: Previous period's rate + maximum adjustment per period = 3.40% + 3% = 6.40%

3rd rate: Introductory rate + maximum lifetime adjustment = 3.40% + 8% = 11.40%

Year 4-6: Rate = 6.40% (lowest of the three)

Year 7-9:

1st rate: 4% over LIBOR = 4% + (1.25%+(6*1%)) = 4% + 7.25% = 11.25%

2nd rate: Previous period's rate + maximum adjustment per period = 6.40% + 3% = 9.40%

3rd rate: Introductory rate + maximum lifetime adjustment = 3.40% + 8% = 11.40%

Year 7-9: Rate = 9.40%

Year 10-12:

1st rate: 4% over LIBOR = 4% + (1.25%+(9*1%)) = 4% + 10.25% = 14.25%

2nd rate: Previous period's rate + maximum adjustment per period = 9.40% + 3% = 12.40%

3rd rate: Introductory rate + maximum lifetime adjustment = 3.40% + 8% = 11.40%

Year 10-12: 11.40%

So, maximum rate which can be charged in 10 years is 11.40%

c-2). The maximum rate change will take effect at the beginning of Year 10, after the third adjustment.