Explanation:
A prepayment option mortgage loan allows the mortgage borrower to pay back the outstanding principal before its predefined maturity date. A mortgage borrower can benefit from the prepayment option if the interest rates decline. The prepayment option is valuable for the borrower when the mortgage rates decline. As the rates will decline, the present value of the remaining monthly payments will be greater than the principal outstanding. Hence, the borrower can gain by paying the principal outstanding in exchange for not having to make further mortgage payments. Think of this along the lines of refinancing. If rates fall, you can pay off the existing mortgage and take on a new one that will come with lower coupon payments.
Q.921 Alison Garry and her partner have recently secured a mortgage to buy a condominium in a beach town in Costa Rica. The purchase price of the condo was $40,000, and the mortgage has an interest rate of 3.25% for a period of 10 years. The mortgage also includes a prepayment option. In light of these circumstances, which of the following statements would be the most accurate regarding the appropriate use of the prepayment option?
A
The use of the prepayment option is appropriate if the mortgage rate increases to 3.75%.
B
The use of the prepayment option is appropriate if the mortgage rate remains at 3.25%.
C
The use of the prepayment option is appropriate if the mortgage decreases to 3.0%.
D
None of the above; prepayment is not a function of interest rates.
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