CHAPTER 5

Adjustable and Floating Rate Mortgage Loans

TRUE/FALSE

1. ARMs were developed because lenders were tired of offering a limited selection of loan
alternatives to borrowers. (F)

2. ARMs help lenders combat unanticipated inflation changes, interest rate changes, and a
maturity gap. (T)

3. Characteristics of a PLAM include an increasing mortgage payment and an adjusting loan

balance tied to an index. (T)

4. A major benefit of a PLAM is the mortgage payment increases closely following borrower
salary increases. (F)

5. PLAMs have been very popular with lenders. (F)

6. Lender’s can partially avoid estimating interest rates by tying an ARM to an interest rate
index. (T)

7. Negative amortization reduces the principal balance of a loan. (F)

8. The floor of an ARM is the maximum reduction of payments or interest rates allowed. (T)

9. ARMs eliminate all the lender’s interest rate risk. (F)

10. The default risk of a FRM is higher than the default risk of an ARM. (F)

MULTIPLE CHOICE

11. A borrower takes out a 30-year adjustable rate mortgage loan for $200,000 with monthly
payments. The first two years of the loan have a “teaser” rate of 4%, after that, the rate can
reset with a 2% annual rate cap. On the reset date, the composite rate is 5%. What would
the Year 3 monthly payment be? (B)

(A) $955
(B) $1,067
(C) $1,071
(D) $1,186
(E) Because of the rate cap, the payment would not change.

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12. A borrower takes out a 30-year adjustable rate mortgage loan for $200,000 with monthly
payments. The first two years of the loan have a “teaser” rate of 4%, after that, the rate can
reset with a 5% annual payment cap. On the reset date, the composite rate is 6%. What
would the Year 3 monthly payment be? (C)

(A) $955
(B) $1,067
(C) $1,003
(D) $1,186
(E) Because of the payment cap, the payment would not change.

13. Assume that the loan in the previous question allowed for negative amortization. What
would be the outstanding balance on the loan at the end of Year 3? (B)

(A) $190,074
(B) $192,337
(C) $192,812
(D) $192,926

14. Which of the following statements regarding negative amortization in the previous question
is true? (D)

(A) The Year 3 payments are less than the interest assessed on the loan, so the outstanding
balance at the end of Year 3 is higher than at the end of Year 2.
(B) The Year 3 payments are more than the interest assessed on the loan, so the
outstanding balance at the end of Year 3 is higher than at the end of Year 2.
(C) The Year 3 payments are less than the interest assessed on the loan, so the outstanding
balance at the end of Year 3 is lower than at the end of Year 2.
(D) The Year 3 payments are more than the interest assessed on the loan, so the
outstanding balance at the end of Year 3 is lower than at the end of Year 2.

15. Which is NOT a component of an ARM? (C)

(A) A margin
(B) An index
(C) A chapter
(D) Caps

16. Which of the following descriptions most accurately reflects the risk position of an ARM
lender in comparison to that of a FRM lender? (D)

Interest Rate Risk Default Risk

(A) Higher Higher
(B) Lower Lower
(C) Higher Lower
(D) Lower Higher

LOAN 1 LOAN 2 LOAN 3 LOAN 4

Initial Interest Rate ? ? ? ?
Loan Maturity (years) 20 20 20 20

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% Margin Above Index 3% --- 3% 3%
Adjustment Interval 1 yr. --- 1 yr. 1 yr.
Points 1% 1% 1% 1%
Interest Rate Cap NONE ---- 1%/yr. 3%/yr.

17. Which loan in the above table should have the lowest initial interest rate? (A)

(A) Loan 1
(B) Loan 2
(C) Loan 3
(D) Loan 4

18. Which loan in the above table is a FRM? (B)

(A) Loan 1
(B) Loan 2
(C) Loan 3
(D) Loan 4

19. With which loan in the above table does the lender have the lowest interest rate risk? (A)

(A) Loan 1
(B) Loan 2
(C) Loan 3
(D) Loan 4

20. Under which scenario is negative amortization likely to occur? (C)

Payment Cap Interest Rates

(A) None Increasing
(B) None Decreasing
(C) 7.5% Increasing
(D) 7.5% Decreasing

21. In order to calculate the APR for an ARM, you must, (C)

(A) Only use the first year’s given interest rate

(B) Estimate interest rates over the life of the loan
(C) Assume the worst case scenario and use interest rates at their highest possible point
over the life of the loan
(D) Use only the first five year’s interest rates because they can easily be estimated and
most people only own a property for five years

22. If an ARM index increased 15%, the negative amortization on a loan with a 5% annual
payment cap is calculated by: (D)

(A) Using the same payment as last year and deducting 5% from the principal balance
(B) Increasing the payment by 5%
(C) Totaling the difference between the payment as if no cap existed and the 5% capped
payment

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 (D) Compounding the difference between the payment as if no cap existed and the 5%
capped payments

23. If one of the terms of an ARM read, interest is capped at 2%/5%, what would that mean? (B)

(A) The borrower can choose the cap he wants by simply circling the appropriate choice
(B) The interest rate has a 2% annual cap rate and a 5% lifetime cap rate
(C) The interest rate has a 5% annual cap rate and a 2% lifetime cap rate
(D) The interest rate has a 2% annual cap rate and a 5% floor cap rate

24. Which of the following is a disadvantage of PLAMs? (C)

(A) Lenders face high levels of interest rate risk under PLAMs.
(B) Fewer homebuyers are likely to qualify for financing using PLAMs in comparison to
CPMs.
(C) The price level used to index PLAMs is measured on an ex post basis and historic prices
may not be an accurate reflection of future price.
(D) All of the above.

25. Which of the following clauses leads to higher risk for an ARMs lender? (C)

(A) Negative amortization is not allowed when interest is not covered by the payment due to
a payment cap
(B) There is floor for payments
(C) Adjustment interval is longer than one year
(D) All of the above

26. The expected cost of borrowing does NOT depend on which of the following provisions? (D)

(A) The frequency of payment adjustments

(B) The inclusions of caps and floors on the interest rate, payment or loan balances
(C) The spread over the index chosen for a given ARM
(D) None of the above

27. Given that every other factor is equal, which of the following ARMs will have the lowest
expected cost? (D)

(A) An ARM with payment caps and negative amortization

(B) An ARM with interest rate caps
(C) An ARM with longer Adjustment interval
(D) An ARM with no caps or limitations

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