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Suppose you just signed a purchase and sale agreement on a new home and you have six weeks to obtain a mortgage. Interest rates have been falling, so fixed-rate loans are now very attractive. You could lock in a fixed rate of 7% (annual percentage rate) for 30 years. On the other hand, rates are falling, so you are thinking about a 30-year variable-rate loan, which is currently at 4.5% and is tied to the six-month Treasury bill rate. A final mortgage option is a variable-rate loan that begins at 5% and cannot fall below 3% but that can increase by only as much as 2% per year up to a maximum of 11%.
1. If you wanted to hedge all risk of interest rate exposure, which financing plan would you choose?
2. What would be your monthly payment on a $100,000. 30 years fixed-rate mortgage?
3. If you took out a fixed-rate mortgage, what would happen to your monthly payment if interest rates increased to 10%.
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