What is the key difference between a fixed-rate loan and an adjustable-rate loan, and how should this be reflected in modeling?

• A. Fixed-rate loans adjust with inflation; ARM does not.
• B. Fixed-rate has variable payments; ARM has fixed payments.
• C. Fixed-rate has constant payments; ARM changes with rate index; modeling must reflect rate resets, caps, and prepayment penalties for ARM.
• D. Fixed-rate loans have no prepayment penalties; ARM always has penalties.

Answer: (C)

The main idea being tested is how interest-rate behavior drives loan cash flows and how to capture that in a model. A fixed-rate loan locks the interest rate for the entire term, so the scheduled payment stays the same each period in a fully amortizing loan. An adjustable-rate loan, on the other hand, tracks a reference index and resets at set intervals; when the index moves, the rate changes and, typically, the payment can change as well, subject to caps and floors. In modeling, you must mirror that rate path: establish the initial rate, determine the index plus margin, identify reset dates, and apply the cap structure so you recalculate the payment and remaining balance at each reset. Include any rate caps and payment caps, floors, and potential prepayment penalties that could affect refinancing or payoff timing. This approach captures how ARM cash flows can shift with rate movements, whereas a fixed-rate loan yields a steady, predictable amortization schedule.