Indexing and Its Limitations

Self-Check Questions

How should an increase in inflation affect the interest rate on an adjustable-rate mortgage?

Hint:

Higher inflation reduces real interest rates on fixed rate mortgages. Because ARMs can be adjusted, higher inflation leads to higher interest rates on ARMs.

A fixed-rate mortgage has the same interest rate over the life of the loan, whether the mortgage is for 15 or 30 years. By contrast, an adjustable-rate mortgage changes with market interest rates over the life of the mortgage. If inflation falls unexpectedly by 3%, what would likely happen to a homeowner with an adjustable-rate mortgage?

Hint:

Because the mortgage has an adjustable rate, the rate should fall by 3%, the same as inflation, to keep the real interest rate the same.