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

A lender offers a 5/1 hybrid adjustable-rate mortgage (ARM) and a 30-year fixed-rate mortgage. The ARM has an initial rate of 4.0%, then resets annually at index plus 2.0% with a 2% periodic cap and a 5% lifetime cap over the initial rate. The index is 3.5% at the first reset and the initial rate was 4.0%. Which statement is correct about the rate at the first reset and the borrower's exposure?

The rate resets to 5.5%, and the borrower remains exposed to further increases limited by the caps. Index of 3.5% plus a 2.0% margin gives 5.5%, a 1.5% rise within the 2% periodic cap. After the fixed period, payments can rise again up to the caps.

  1. ARate becomes 5.5%; borrower is exposed to rate increases after the fixed period, limited by capsCorrect
  2. BRate becomes 6.0%; the periodic cap is breached
  3. CRate stays 4.0% because hybrids are fixed for the full term
  4. DRate becomes 5.5%; the borrower is fully protected from future increases

Explanation

Fully indexed rate = 3.5% + 2.0% = 5.5%. This is a 1.5% rise from 4.0%, within the 2% periodic cap, so 5.5% applies. The borrower stays exposed to later increases, bounded by the periodic and 9% lifetime ceiling (4% + 5%). Options B and D misstate the cap and the exposure.

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