George would like to borrow $114,000 using an adjustable-rate mortgage instrument. He has the following two options available:
a. 1-year ARM, 15-year amortization schedule, 4.50% initial interest rate, 2% margin, 2% annual interest rate cap, 4% lifetime cap.
b. 1-year ARM, 20-year amortization schedule, 4.25% initial interest rate, 1.75% margin, no cap.
Assume that each of these loans is indexed to the 1-year Treasury rate, and that this index is expected to have a value of 5% at the end of the first year and 7.5% at the end of the second year.
If George’s expected holding period is 3 years, which of these two alternatives has the lowest effective borrowing cost?