Comparing Present Value Cost Differentials between Fixed‐ and Adjustable‐Rate Loans: A Mortgage Simulation

Abstract When a borrower chooses between a fixed‐rate and an adjustable‐rate loan, he is doing so based on expectations of future interest rates and the expected life of the loan. This paper demonstrates how Monte Carlo simulation can be employed to assist in decision making when the borrower is confronted with the choice of fixed or adjustable‐rate mortgages. Present value costs of future mortgage payments are modeled using actual lending parameters offered over a 50‐month period, at varying borrower discount rates, and with different mortgage holding periods. The selection of a fixed‐rate or a variable‐rate mortgage is shown to be sensitive to mortgagee holding period and discount rates as well as to market conditions.