You are a new loan officer with Alpha Mortgage, and the manager of the loan department has just presented a problem to you. He is unable to complete the APR calculation on an adjustable rate mortgage which a borrower applied for yesterday. The loan features initial payments based on a 10 percent rate of interest, while the current composite rate on the loan is 13 percent. No discount points have been paid by any party to the transaction, and any difference between borrower payments and the interest payment required at the composite rate will be accrued in the mortgage balance in the form of negative amortization. The mortgage amount desired by the borrower is $65,000 for a 30-year term, but a one-time mortgage insurance premium of $2,400 is being funded as a part of the loan amount, making the total loan balance $67,400. The borrower is paying $1,600 in prepaid finance charges at closing.
Required:
a. Determine the APR, assuming that the ARM is made with a 2 percent annual and 5 percent over-the-life interest rate cap.
b. In what way does the APR disclosure aid the borrower in understanding the terms of this specific loan agreement? What are some of the problems with the APR calculations on ARMs?
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