Suppose I have two mortgages that has the same amount of loan and maturity. One is fixed rate. One is fixed for the first n years and then after that it becomes LIBOR+x rate. Then how do I compare the two mortgages?I suppose this has something to do with interest rate model and swaps. Does anyone know any good intro books on this topic?I have experience implementing stochastic volatility models using Monte Carlo with Euler discretization. So I guess I can handle interest rate processes if needed. Thanks a bunch!

You can start by comparing their present values. Simple cashflow discounting for fixed mortgage. For ARM can discount first n years of fixed cashflows and fixed spread from then on. Libor component should be worth approximately par at the end of the fixed rate period (n years).If price is similar then the only incentive to go to fixed loan is having a cap in case rates go up. If rates go down, you immediately benefit on the ARM whereas on the fixed rate you have to go into a costly refi.

QuoteOriginally posted by: sportbillyYou can start by comparing their present values. Simple cashflow discounting for fixed mortgage. For ARM can discount first n years of fixed cashflows and fixed spread from then on. Libor component should be worth approximately par at the end of the fixed rate period (n years).If price is similar then the only incentive to go to fixed loan is having a cap in case rates go up. If rates go down, you immediately benefit on the ARM whereas on the fixed rate you have to go into a costly refi.Thanks for your reply. I know how to do NPV analysis. But what is a "fixed spread"? And how to value it?

it is the extra coupon margin that you need to pay on top of the index, usually is the six-month LIBOR rate. The extra margin paid by the mortgage obligor accounts for credit risk, prepayment option held by the obligor, etc

QuoteOriginally posted by: umvueBut what is a "fixed spread"? And how to value it?look for "OAS", option adjusted spread.