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Introduction
The increasing cost of housing during the 21st century pushes people to opt for mortgages despite having a low income. As a result, banks provide loans to help individuals settle mortgage charges. The loans depend on the type of mortgage selected by the loanee. However, during the purchase of the first mortgage, individuals find it difficult to choose between fixed-rate mortgages (FRM) and adjustable-rate mortgages (ARM). It is evident in a case involving two newbie buyers, who decided to choose different types of mortgages when the bank offered them a 30-year $150,000 loan with a 3% interest rate for the first 4 years, while the remaining years’ interest rate is 5.5%. Although first-home buyers might not know the benefit of prioritizing ARM over FRM, the calculation reveals that it saves money.
Reasonable Answer
Adjustable-Rate Mortgages
The most fundamental sort of mortgage loan is a fixed-rate mortgage. The interest rate offered by the bank at the time of issuing the loan applies to the whole loan term. For instance, if the fixed rate is 3% for a 30-year loan, the payments will be based on 360 installments obtained from the product of the entire loan settlement period and the number of months in a year. In this case, payment will remain the same for 30 years. The main benefit of a fixed-rate loan for the buyer is that they will always be aware of the monthly payment (Guren et al., 2021). In terms of the return, banks will receive huge interest on that loan the banks also know what to anticipate.
Fixed-Rate Mortgages
Interest rates spiked a few years after mortgage loans gained popularity. For purchasers with good credit, FRM could be as high as 16–20%. Therefore, ARM was introduced to assist customers, who could not apply for loans with high-interest rates. ARMs fluctuate following some benchmark interest rates, such as the federal funds rate, which is the rate that banks use to lend money to one another and is determined by the Federal Reserve. Banks would provide introductory rates at a discount to persuade borrowers to accept an adjustable-rate mortgage. For instance, if the fixed rate for a 30-year loan was 5.5%, the starting rate for an adjustable-rate loan might be 3%. It represents a $300 difference in the loan payment for a $150,000 loan. For the second buyer, the introductory rate was 3%. According to Fan et al. (2022), numbers are used to identify ARMs, such as “5/1 ARM”. Therefore, an introductory interest rate of 3% will be available for the first four years, and will then be reset every year afterward.
Solution
The first buyer will pay $752.01 per month for the 30-year mortgage. Given that the house was sold after 10 years, it means that the owner paid $752.01 per month for 10 years (120 Months).
Therefore, $752.01*120=$90.241.20
The second buyer paid $629.14 for the first four years at a 3% mortgage rate. Therefore, in the first four years, the second buyer paid $629.14*48=$30.198.72
In the 5th year, the mortgage rate was adjusted to 5.5%. At this rate, the buyers paid $839.12 per month for six years (72 months). Therefore, for the rest of the years, the second buyers paid a total of $839.12*72=$60.416.64
In 10 years, the second buyer paid First 4 years payment + last 6 years payment = total payment for 10 years; $30.198.72+$60.416.64=$90.615.36
Conclusion
The current paper examined FRM and ARM to establish where home buyers pay less. Compared to the first buyer, the second buyer paid more before selling the house. The second buyer paid more by $374.16. For the first 4 years, the second buyer paid less making ARM cheaper in the initial years. Therefore, ARM enables one to save hundreds of dollars in the initial years and if they are lucky, the subsequent rate may be lower than the initial rate. However, ARM can be devastating in the long run, especially if the interests are adjusted to higher rates that could translate to expensive repayments.
References
Fan, Y., Yang, Z., & Wang, Y. (2022). How is financial literacy important in emerging mortgage markets? Evidence from urban China. SSRN Electronic Journal. Web.
Guren, A. M., Krishnamurthy, A., & Mcquade, T. J. (2020). Mortgage design in an equilibrium model of the housing market. The Journal of Finance, 76(1), 113-168. Web.
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