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Case Study: Mortgage Application 

Principal: $500,000

Assume that the loan is an ‘interest-only’ loan.

Option 1: Variable Rate

a) The current rate of the loan (fixed for 2 years): 4.12%
b) The interest rate is unknown after Year 2.
c) The duration of the loan is 7 Years.

Option 2: Fixed Rate

a) Refinance the current loan and pay pre-payment penalty of (add into the cost of the loan) $25,000
b) Lock-in a fixed rate of interest of 4.00% for the 7-Year Term

Option 3: Interest Rate Swap 

a) Lock-in a fixed interest rate of 3.5%.
b) Pay an upfront cost of swap (add into the cost of the loan) of 3.00%.
c) Pay the pre-payment penalty of $25,000 (add into the cost of the loan).
d) The term of the loan is 7 years.

Deliverable: Draft a memo to your client outlining your decision-making process. Pay particular attention to the uncertainty created by the variable rate of interest included in Option 1.This memo should provide insight into your analysis and help your client reason through their impending decision. Your memo also needs to convey your understanding of the problem and the solution.