Question

You are currently maintaining a conventional 30-year mortgage loan with your bank and the annual interest rate is 8%. Your bank manager now offers you a 30-year adjustable rate mortgage (ARM) at 2% but the rate will be adjusted once each year. Evaluate your current mortgage and the new option in terms of the following: Risk that the monthly payment will change over the next 30 years, and, interest rate risk. Explain your understanding on the risk involved in this question and its impact on both financial institutions and customers.

Answer 1

Parameter	Current Mortgage	New Option
Risk that the monthly payment will change over the next 30 years	No such risk, the interest rate is fixed and hence the monthly payment is fixed	It bears the risk of change in monthly payment on every reset date and that will be once every year.
Interest rate risk	The interest rate is fixed over the term and hence there is an interest rate risk. The present value of your mortgage will keep changing based on the changes in the interest rate	There will be no interest rate risk here as it is an adjustable rate mortgage
Impact on financial institution	The interest income of the financial institution remains fixed. It's known and certain There is no variability in the income. This can lead to a better planning.	The interest income is a variable. And it will change on every reset date. So the institution is subjected to variability in its interest income.
Impact on customers	The interest expense of the customer remains fixed. It's known and certain There is no variability in the expense. This can lead to a better planning.	The interest expense is a variable. And it will change on every reset date. So the customer is subjected to variability in its interest expense.