Question

Lenders prefer adjustable rate mortgages because the interest rate risk is shifted to the borrower. Under what circumstances do you think a borrower will prefer an adjustable rate mortgage? What kind of terms could be inserted in the ARM to restrict the interest rate risk for the borrower as well as lender?

Answer 1

Borrowers may prefer ARMs if they expect lower future interest rates or if they're not planning to keep the property long-term. Terms like rate caps, initial fixed-rate periods, and rate floors can mitigate risks for both parties in an ARM agreement.

Step-by-step explanation:

A borrower might prefer an adjustable-rate mortgage (ARM) under circumstances where they anticipate interest rates to decrease over time or when they plan to sell or refinance the home before the interest rate adjusts significantly. To restrict the interest rate risk for the borrower, certain terms can be included in an ARM, such as:

• A cap on the interest rate which sets a maximum limit on how high the rate can go.
• A period of fixed interest before the rate changes, giving the borrower stability in the initial years.
• A rate floor to ensure the rate does not fall below a certain point, which can be advantageous for the lender.

These terms help to balance the risk between the borrower and the lender, making ARMs more manageable for borrowers while still providing the flexibility lenders desire.