Final answer:
It is false that the default risk premium on Adjustable Rate Mortgage (ARM) loans is greater than that on Fixed Rate Mortgage (FRM) loans. ARMs have a mechanism that adjusts the interest rate with inflation, hence lowering the need for a high risk premium. While ARMs offer lenders protection against inflation, they present different risks like payment shock for borrowers.
Step-by-step explanation:
The statement that the default risk premium charged by the lender on Adjustable Rate Mortgage (ARM) loans will be greater than the premium charged on Fixed Rate Mortgage (FRM) loans is false. The reason for this is rooted in the nature of how ARM loans are structured. With ARMs, the interest rate adjusts with inflation, which means that if inflation increases, so does the interest rate on the loan. This adjustment mechanism protects lenders from the risk of inflation reducing the value of the repayment. As a result, the lender does not need to charge as high of a risk premium compared to fixed-rate loans, where the lender bears the risk of inflation affecting the real value of the payments they receive.
During periods of high inflation, lenders face a diminished real interest rate on FRM loans because the payment stays constant while inflation erodes the purchasing power of the money repaid. In contrast, ARM loans mitigate this issue by allowing the interest rates to keep pace with inflation, thus preserving the lender’s real earnings. This is one of the primary reasons why ARMs generally carry a lower initial interest rate compared to their fixed-rate counterparts. However, it's essential to note that while ARMs may be less risky for lenders in terms of inflation, they introduce other kinds of risks for both the lender and the borrower. Lenders have to manage the risk of borrower default that can come from payment shock when rates adjust upward, and borrowers take on the uncertainty of their future loan payments varying. These complexities became painfully evident during the housing crisis that precipitated the Great Recession, when many borrowers with ARM loans could no longer afford their payments after rate adjustments.