Your friend is buying a house and is going to take a $320,000 mortgage. You see that rates for 30 year fixed rate

mortgages are 4.75% and 5/1 Adjustable rate mortgages (also 30 years, monthly payments) are 3.85%. The

adjustable mortgage has a 2% yearly cap, a 5% lifetime cap, and a floor of 1.5% on the interest rate. The floor

means that the rate will never drop below 1.5%. The yearly cap means that that the interest rate cannot adjust

more than 2% in either direction each time they adjust and cannot adjust more than 5% total over the life of the

mortgage (relative to the original 3.85%.) Your friend needs some help and turns to you.

a. (5 points) If he is planning to be in the house for 5 years, which mortgage is the better choice? Why?

b. (5 points) Assuming interest rates will remain at their current levels, which mortgage is the better choice?

Why?

c. (10 points) Under the worst-case scenario, assuming rates go up as quickly as allowed under the terms of

the agreement, how long will it take for the ARM to be an inferior choice to the fixed rate mortgage?

d. (10 points) Based on the assumption in part c. (i.e. worst case for interest rates), please briefly advise your

friend on this mortgage decision. What should they do if they plan to be in the home and loan for a few

months, a few years, and so on?