A “teaser rate” is a low, introductory interest rate that is typically offered for the first few months as an incentive to choose a certain mortgage program. The concept is somewhat similar to offers you see for 0% APR credit cards.
Teaser rates are common in adjustable-rate mortgages, as most are now hybrid ARMs. In other words, they’re fixed for a certain period of time before becoming adjustable.
During those five years, you’re essentially getting a “discount” for taking on the risk of a loan that will eventually become adjustable.
Banks and lenders are essentially banking on you getting stuck with a higher mortgage rate later down the line. Of course, your rate may adjust higher OR lower, so it’s not a defined risk.
Many home equity lines also come with teaser rate specials, such as 1% below prime for the first three months, or prime minus 2% for the first six months.
These teaser rates are limited in the length of time that they’re offered, but are not considered negative amortization, despite being offered below the actual interest rate.
This contrasts the 1% start rate commonly found on option arms, which aren’t really teaser rates at all. With an option arm, you’re essentially making a payment that doesn’t satisfy the total amount of interest due each month, which leads to that interest being tacked onto the principal balance.
These types of loans are very dangerous, especially if home prices fall and you find yourself stuck with an underwater mortgage.
Teaser Rates Provide Mortgage Payment Relief
A teaser rate provides a great opportunity to pay lower monthly mortgage payments for the first few months (or years) of the loan. The savings can be rather considerable depending on the actual interest rate of the mortgage product versus the teaser rate.
Let’s look at an example of a teaser rate:
Home Equity Line of Credit
Prime rate: 4.50%
Teaser rate: 1% below prime for first 3 months
Your actual interest rate is 6.75%, or prime plus the 2.25 margin. But for the first three months, the bank or lender will offer an interest rate of 3.50%.
This lower teaser rate, designed to draw you in the door, can amount to substantial savings, and though you’re paying less than your actual interest rate, the loan is not amortizing negatively.
In other words, you won’t owe that money back later since the teaser rate is treated as the fully-indexed interest rate for the few months it is offered. This is a pretty important distinction, so make sure you know what is actually being offered.
The same goes with a 3/1 or 5/1 ARM, where you get a discounted rate for the first three or five years before the rate is determined using the margin and corresponding mortgage index. During those years, you can save a lot of money versus a 30-year mortgage rate.
When shopping for a mortgage, always keep your eye out for teaser rates, as they can save you a ton of money. But don’t be fooled into thinking you can pay less forever. And don’t choose a mortgage program based on its teaser rate alone.
Eventually the interest rate will rise, and the payment shock could take you by surprise, or end up costing you more than a fixed-rate mortgage option would have.
Tip: There shouldn’t be an adjustment to fee for a teaser rate, but it may reduce the rebate the bank or mortgage broker will receive. And you may be able to secure a slightly lower margin if you opt-out of the teaser rate. But many teaser rates can provide savings that will prove more valuable than a small difference in margin.