Question

Question

a. Discuss two types of risk that a lender may face if he offers a fixed-rate mortgage loan to a borrower?

b. Can the lender reduce the risks you mentioned in (a) if he uses the price-level-adjusted mortgage (PLAM)? Explain.

c. Discuss two limitations of PLAM.

d. If you are going to borrow, would you prefer an adjustable rate mortgage tor a fixed rate mortgage? Explain.

Answer 1

a) The two types of risk faced by the fixed rate mortgage lender are:

· Reinvestment risk: If the interest rate falls then the borrower might choose to refinance the mortgage and then in that case lender will have to lend again the money at lower interest rate.

· Inflation risk: If during the period of mortgage inflation goes up significantly, then the inflation adjusted return for the lender would be significantly affected and he might be left in a scenario where the real returns are negative.

b) A price level adjusted mortgage is mortgage loan plan in which the lender does not change the interest rate but the principal outstanding is adjusted on the basis of inflation. This method does reduce the risk associated with the inflation risk; this method would be quite similar to treasury inflation protected securities (TIPS) but he still faces the reinvestment risk. If the interest rate falls then he will have to reinvest the proceeds at lower rates of interest.

c) Two limitations of price level adjusted mortgage are:

· With price level adjusted mortgage, the periodic payment might change frequently if the inflation rate is changing and this might not be suitable for many borrowers.

· This type of mortgage does not address the reinvestment risk from the perspective of lender because he will have to reinvest the proceeds at lower rates of interest, if interest rates fall and borrower choose to refinance the loan.

d) What type of mortgage do I prefer depend on the what type of interest rate expectation do I have and whether I am open to making flexible periodic payment of the loan? If the interest rates are expected to rise then it is better to finance the loan at fixed rate mortgage, in that case you would not have to pay high interest rate but if the current inflation rate is high and you are expecting the inflation to fall then it is better to choose either variable rate mortgage or adjustable rate mortgage. If the interest rates fall then you will benefit in the case of adjustable rate mortgage because the interest rate charged on the loan would be less and the periodic payment would reduce.