If yo are uncertain of how the cash flows look, consider the following spreadsheet example . Traditional providers of mortgages are banks and savings and loans. Mortgages tend to have long maturities and accordingly have high interest rate exposure. Financial intermediaries have found many ways to lessen their exposure to this risk. For more on the types of mortgages , please check out these other notes.
Mortgages are subject to two main risks.
The risk of default and the risk of interest rate fluctuations. The credit-giving institution attempts to lessen default risk through diversification, credit checks, and appraisals. The interest rate risk is more troubling and has shaped much of what we see in the mortgage market. In an ARM the interest rate increases as market interest rates go up. This transfer is not complete as there is a lag in adjustments and most mortgages have caps that prevent the rate from moving more than a certain percentage.