A homebuyer plans to sell their house in 4 years. A 30-year fixed-rate mortgage offers 7.0%, while a 5/1 ARM offers 5.5% for the first 5 years. The buyer says 'ARMs are risky — I'll take the fixed rate to be safe.' What is the flaw in this reasoning?
AThe buyer is correct — fixed-rate mortgages are always the safer choice regardless of how long you plan to stay
BSince the buyer plans to sell within the ARM's 5-year fixed period, they will never face any rate adjustments; the ARM delivers the lower rate with zero additional rate risk compared to the fixed mortgage for this buyer's actual time horizon
CThe buyer should always choose the ARM because ARMs consistently result in lower total interest paid than fixed-rate mortgages
DThe ARM is only advisable if interest rates are expected to fall significantly over the next 5 years
ARMs are 'risky' only if you hold the loan past the fixed introductory period. A buyer selling in 4 years never reaches the adjustment phase of a 5/1 ARM — they capture the lower rate for 4 years and exit before any uncertainty begins. The fixed rate's predictability protects against rate increases over a 30-year horizon; for a 4-year horizon, that protection is unnecessary and costs real money (1.5% higher rate × 4 years of payments). The relevant risk horizon is your actual holding period, not the loan's maximum term.
Question 2 Multiple Choice
You pay 2 discount points ($6,000 on a $300,000 loan) at closing to reduce your mortgage rate from 7.0% to 6.5%, saving $100 per month. When does paying these points turn out to be the wrong financial decision?
AAlways — upfront costs never justify long-term savings because of the time value of money
BIf you sell, refinance, or pay off the loan before month 60 (5 years), because you will have paid $6,000 upfront but recovered less than $6,000 in monthly savings before the loan ends
COnly if interest rates fall further after closing, making the purchased rate uncompetitive
DNever — a lower interest rate always saves money over any loan duration
The break-even calculation: $6,000 upfront ÷ $100/month savings = 60 months (5 years). Before month 60, you've paid more than you've recovered. If you sell at year 3 (month 36), you've recovered only $3,600 of the $6,000 cost — a net loss of $2,400. Points only pay off when you hold the mortgage past the break-even point. Since most Americans refinance or move within 7–10 years, high-point deals deserve scrutiny. The question is never 'does a lower rate save money?' but 'do I stay long enough to recoup the upfront cost?'
Question 3 True / False
A 30-year mortgage is financially superior to a 15-year mortgage because the lower monthly payment gives you the flexibility to invest the difference and come out ahead.
TTrue
FFalse
Answer: False
This is a misconception: the 30-year mortgage is only better *if* you actually invest the payment difference. In theory, if the difference were reliably invested at a rate exceeding the mortgage rate, the 30-year could win. In practice, most people spend the payment difference rather than invest it — converting 'theoretical flexibility' into actual overpayment of hundreds of thousands of dollars in interest. The 15-year typically also carries a 0.5–0.75% lower rate, widening the gap further. The comparison must be made explicitly with realistic assumptions, not assumed.
Question 4 True / False
A rate lock guarantees that your quoted mortgage interest rate will not increase between the lock date and your closing date, regardless of how market interest rates move.
TTrue
FFalse
Answer: True
A rate lock is exactly this: a lender's contractual commitment to honor a quoted rate for a specified window (typically 30–60 days). If market rates rise during that period, your locked rate is protected. If rates fall, you may not benefit (you're locked in), though some lenders offer 'float-down' provisions for a fee. The practical implication is that once you've found a rate you're comfortable with and are confident the deal will close on time, locking protects you from rate increases during the closing process — which can last weeks.
Question 5 Short Answer
You are choosing between a 5/1 ARM at 5.5% and a 30-year fixed at 7.0% for a home you plan to own for 20 years. Walk through the key considerations for this decision.
Think about your answer, then reveal below.
Model answer: The ARM saves money during the first 5 years (lower rate = lower payments), but after year 5 it resets annually to a market-based rate. For a 20-year holding period, you face 15 years of rate uncertainty. Key considerations: (1) How much do you save in years 1–5? Calculate the monthly payment difference and total savings. (2) What happens if rates rise significantly at adjustment — can you absorb a $300–500/month payment increase? (3) Could you refinance to a fixed rate later if rates become unfavorable? (4) What is your view of future rate trends? The fixed rate is a hedge against rising rates over 20 years; the ARM is a bet that you can manage adjustments or refinance before they become painful.
There is no universally correct answer — the right choice depends on your financial cushion, risk tolerance, and view of future rates. The point is to make the decision *explicitly* rather than defaulting to a rule of thumb. The ARM is not inherently risky for 20-year ownership, but it requires a plan for the adjustment phase.