Question: Consider a $120,000, 25-year amortization ARM with monthly payments and annual interest rate adjustments. The initial interest rate is 6.5%. The index for the loan is one-year U.S. government bonds, currently yielding 4.75%. The loan has a margin of 250 basis points, and interest rate caps of 2% per year at each adjustment and 4% over the life of the loan. It is expected that one-year bond yields will increase to 6.25% over the second year (at the end of Year 1) and to 8% during Year 3 (at the end of Year 2).
a. Compute the payments and balances over the first three years.
b. Assuming a loan origination fee of 2 points paid up front, determine the yield (effective cost) assuming a three-year holding period.