Question: The Friendly Loan Company Mr. and Mrs. Green have found the house of their dreams and are attempting to finance its purchase. The Friendly Loan Company has offered them two options, each of which provides the Greens with a $100,000 loan. Option One calls for a fixed interest rate of 10.5 percent per annum; this loan would be fully amortized with level annual payments over a 20-year term. Premature repayment of the mortgage is permitted at any time but a prepayment penalty of one year's interest is levied on the amount prepaid. Option Two involves a variable-rate loan; the initial interest rate is set at 8.5 percent per year and the maturity is initially set at 20 years. The mortgage payment is initially computed on a basis that will fully amortize the loan over the maturity. The interest rate on this loan is re-evaluated each year, and if market rates have changed more than a stated amount from the level of rates existing when the loan was originated, then the interest rate on the Greens' variable-rate loan would be adjusted either through an increase (decrease) in the mortgage payment (leaving the maturity unchanged); or through an extension (reduction) of the maturity date (leaving the amount of the annual payments unchanged). If the Greens choose the variable-rate loan, they must indicate at that time which adjustment method they want employed when a change in the interest rate is called for. Premature repayment of the mortgage is permitted without penalty. The Greens call on you for assistance in evaluating their options. You learn that they expect to live in the house for 10 years before selling it. At that time, the Greens would repay the mortgage loan in full. Comparing your interest-rate forecasts with the variable-rate loan provisions, you conclude that it is most likely that at the end of 4 years the variable rate will be increased to 12 percent, where it is likely to remain for the following 6 years. There are no other costs or fees to consider. Tax considerations, if any, can be ignored.
(a) Given these assumptions, assist the Greens by providing them with the series of payments (including end-of-term payments) called for under each of the following options: Option One: Fixed-Interest Loan Option Two
(i): Variable-Interest Loan with variable mortgage payments and fixed maturity Option Two
(ii): Variable-Interest Loan with variable maturity and fixed annual mortgage payments
(b) In choosing between the various options, what are the main considerations and trade-offs facing the Greens? Which option would you recommend?