Question

The initial rate on an ARM will typically be

A) relatively low to benefit the homeowner.
B) relatively high to allow the bank to recoup costs.
C) about the same as a fixed rate loan on the same maturity.
D) set by state law.

Answer 1

The initial rate on an adjustable-rate mortgage (ARM) is typically low to benefit the homeowner, as the lender's inflation risk is minimized, allowing for a lower risk premium on the interest rate.

Step-by-step explanation:

The initial rate on an adjustable-rate mortgage (ARM) will typically be relatively low to benefit the homeowner. This lower rate compared to a fixed-rate loan is possible because with an ARM, the lender is protected against the risk that higher inflation will reduce the real value of the loan repayments. As a result, the lender can offer a lower initial rate, since the risk premium part of the interest rate can be lower. However, with this type of loan, if the inflation rate rises, the interest rate on the loan will also increase proportionally.