A woman is buying a house in which she expects to live for at least until her retirement - which is twenty years from now. The house is appraised at $400,000 and she asks her Commercial Bank for a 30-year conventional mortgage loan to finance $300,000. The banks loan officer offers two types of mortgages. One is a fixed rate mortgage (FRM), the other is an adjustable rate mortgage (ARM). Each has a different interest rate that will be in effect at loan origination. The FRM has a slightly higher rate but that rate will not change for the thirty years needed to fully amortize the mortgage. The ARM has a lower initial rate but is subject to a change in rate.

a. The bank offers these two types of mortgages with different initial loan rates because of differences in risks to the banks. Identify the differences in risks that justify this?

b. Which choice do you think would be more attractive to this borrower and why?