Question

A bank customer is buying a Single-Family Residence (SFR) appraised at $400,000 and asks for a 30-year conventional mortgage loan to finance $300,000. Her FICO score and her Debt-to-Income (DTI) are sufficient for this mortgage. She asks what the difference in rate would be for an FRM or an ARM with no points required for either. She anticipates living in the SFR for at least 20 years until her retirement.

a. What are the differences in risks that cause the bank to offer both types of mortgages yet with different initial loan rates?

b. Which option do you think will be more attractive to the borrower – and why?

Answer 1

a. Fixed rate mortgages (FRM) and adjustable rate mortgages (ARM) have different types as well as different quantum of risks associated with them and as such banks, even though they offer both types of mortgages, have different initial loan rates.

Generally rates of ARMs are higher than the rates for FRMs and this reflects the higher level of risks for banks in case of ARMs. This is because in case of ARMs banks are exposed to severe interest rate risk. This is particularly true for banks that have short-term liabilities in their balance sheet. Secondly default risk is also higher in case of ARMs and lack of simplicity as well as standardization does not always encourage securitization.

b. The borrower should go for a FRM. This is because FRM will guarantee payment stability for the borrower over the life of the mortgage. The borrower will also stay protected against any interest rate increase in future.

In this case the borrower will stay in the house for at least a period of 20 years so she can go for a 20 year FRM.