You have been living in the same house for just about two years and you are thinking about renancing your $100, 6% annual (1 payment per year) 5 year Fixed Rate Mortgage (FRM) at the end of the second year for the last 3 years. Your original loan had no points and carries a 2% prepayment penalty.

You have several options:

-Your first alternative is to not refinance and keep your original loan as it is.

-Your second alternative (call it loan 2) would be to refinance today with another 5 year FRM with a mortgage rate of 5%. The new loan charges 1 point at origination and prepayment penalties of 0% of the amount prepaid.

-Your third alternative (call it loan 3) would be to refinance two years from now (hence at the end of year 4) with another 5 year FRM with a mortgage rate of 3%. This second new loan would charge this time 3 points at origination and have a 1% prepayment penalty of the amount prepaid.

-Finally your last alternative would be to refinance twice: one rst time with loan 2 right now and another time at the end of year 4 with loan 3.

Assume that if you do refinance you will live there for as long as needed to fully amortize any of the loans contemplated.

a. Derive the Effective Cost of Refinancing (ECR) for the four options previously listed as of the end of year 2. For this purpose detail very specically the cash fows under all 4 options as of year 0 and as of year 2. Please indicate clearly how you would calculate the ECR.

b. Determine your net gains from renancing for each one of the four alternatives as of the end of year 2. Again for this purpose, please build a table showing clearly what your cash flows would be

c. Conclude. Which alternative would you choose? Consider the possibility that terms on loan 3 are not guaranteed. Comment on the risks to which you are exposed.