Part 1

You are buying a $350,000 home and are deciding between two fixed rate mortgage options. The 80% LTV option has an interest rate of 6% over 30 years. The 90% LTV option has an interest rate of 6.5% over 30 years with 2 discount points.

• What is the incremental borrowing cost when choosing the 90% LTV option over the 80% LTV option?

• Why is the effective borrowing cost higher for the 90% LTV option?

Part 2

Assume that you chose the 80% LTV mortgage from the previous section, but after 10 years are thinking about refinancing for $1,500. You will only be in the home for another 5 years. The new loan would be an ARM. Interest rates on 20-year ARMS are currently 3%. Interest rates are expected to increase to 4% in years 2 and 3 and then to 5% in years 4 and 5.

• Find the return on your $1,500 refinancing cost. Should you refinance?

• If interest rates rose faster than expected, how might this change your answer? (No calculation is needed. Explain in words.)

• How would larger than expected increases in interest rates impact the supply and demand for homes?