Final answer:
The question refers to a prepayment option in a mortgage contract that allows repayment with a penalty. This term isn't specific to an adjustable-rate mortgage (ARM), but could apply to any mortgage type. The penalty assessed is the greater of three months' interest or the interest rate differential.
Step-by-step explanation:
A mortgage that can be repaid at any time with a 3-month interest penalty or the interest rate differential, whichever is higher, refers to a prepayment option available in some mortgage contracts. This isn't specific to an adjustable-rate mortgage (ARM), which is a loan used to purchase a home where the interest rate varies with market interest rates. Instead, it describes a prepayment term that could apply to any type of mortgage (whether it's an ARM or a fixed-rate mortgage). Mortgage contracts often have clauses that allow borrowers to pay off their loan early. However, to compensate the lender for the potential loss of future interest payments, a penalty is typically assessed. This penalty is usually the greater of a few months' interest or the interest rate differential, which is a calculation comparing the original loan's interest amount against the current market rates for the remaining period of the original term. If a person with an ARM experiences a sudden decrease in inflation by 3%, it's likely that the market interest rates would decrease, and thus the interest on the ARM would likely adjust downward, making the monthly payments smaller. This could be beneficial to the homeowner, as their borrowing costs would be reduced.