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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

A $200,000 mortgage has a 5% annual rate with monthly payments. For the first 12 months the borrower pays interest only (monthly rate 5%/12), after which the loan fully amortizes over the remaining 348 months. Compared with a conventional fully amortizing 360-month loan at 5%, which statement is correct?

The interest-only loan still owes the full $200,000 after 12 months, whereas the conventional loan has already paid down some principal. Because the higher balance must be amortized over 348 months at the same rate, the post-interest-only payment exceeds the conventional payment, a payment shock.

  1. AThe balance after 12 months is lower under the interest-only loan
  2. BThe balance after 12 months is $200,000 under the interest-only loan, above the conventional loan balance, so the later payment must be higher than the conventional paymentCorrect
  3. CThe later payment is identical because the rate is the same
  4. DThe later payment is lower because the interest-only period reduced total interest

Explanation

During the interest-only period no principal is repaid, so the balance stays $200,000. The conventional loan has repaid some principal in 12 months, so its balance is lower. Repaying a larger balance over fewer months (348 vs 348 remaining on the conventional loan but with higher balance) requires a higher payment than the conventional payment.

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