Assume that a lender offers a 30-year, $150,000 adjustable rate mortgage (ARM) with the following terms:

Initial interest .5 percent

Interest = 1 year Treasuries

Payment reset each year

Margin = 2 percent

Interest rate cap = 1 percent annually, 3 percent lifetime

Discount points = 2 percent

Fully amortizing, however negative amortization allowed if interest rate caps reached

Based on estimated forward rates, the index to which the ARM is tied is forecasted as follows:

Beginning of year (BOY) 2 = 7 percent; (BOY) 3 = 8.5 percent; (BOY) 4 = 9.5 percent; (EOY) 5 = 11 percent.