Real-estate investment

John obtained an adjustable rate mortgage (ARM) loan of $5 million for 25 years from a bank to purchase an apartment at Cheung Sha Wan four years ago. The mortgage interest rate was Prime rate minus 2.6%, but in the first three years, John was allowed to pay a teaser rate of 1% only. Since the loan origination, the prime rate had not been changed over the last three years and it stood at 5.25%. However, payments after three years have to be adjusted sufficiently to fully amortize the loan at maturity.

a) Suggest TWO possible reason for Johns decision to use an ARM instead of a fixed-rate mortgage. (2 marks)

b) Discuss a risk that John has to face when using the ARM. (2 marks)

c) Discuss one advantage and one disadvantage when a bank uses ARM. (4 marks)

d) Is Price Level Adjusted Mortgage (PLAM) a kind of ARM? Explain. (3 marks)

e) Base on the teaser rate, what were Johns monthly payments in the first three years? (2 marks)

f) What was Johns loan balance at the end of Year 3? (3 marks)

g) If the prime rate rose to 6% at the end of Year 3, and the interest rate has to be reset at the start of Year 4, what would Johns new monthly payments be and what would the percentage rise in his monthly payments be? (4 marks)