Bozo Buffoon is trying to decide how to finance the purchase of his first home, a typical yuppie starter castle. He has asked you to provide some advice regarding loan choice and how much to borrow.

The facts of the situation are as follows: Price of house: $500,000 Bozo's salary: $160,000 Bozos cash and other liquid assets $180,000 Bozos marginal tax rate 30%

Mortgage Option 1: Fixed interest rate: .0375 Term: 15 years Front end fees 2% of principal (no points)

Mortgage Option 2: Variable interest rate: 5/1 ARM .0325 for first five years, adjustable annually thereafter Max annual adj = +/-2% Max total adj = +-6% Rate adjusted to external benchmark Term: 30 years Front end fees: 2% of principal (no points)

Mortgage Option 3: Fixed interest rate: .04 Term: 30 years Front end fees: 2% of principal

For all loan options, the bank will loan up to 90% of the price of the house. Assume all fees are for transactions costs and hence not tax-deductible. Ignore mortgage insurance.

(1) which loan and (2) how much to borrow. I recommend starting out by selecting a loan size and doing the amortizations for all loan options. Then, you can vary the loan size and see what happens. What happens to what? Try an IRR and a NPV. But what discount rate is correct for the NPV calculation?