A “teaser rate” is a low, introductory interest rate that is typically offered for the first few months or years as an incentive to choose a certain mortgage program.
The concept is somewhat similar to offers you see for 0% APR credit cards. You get a discount for X amount of time before the actual, higher rate kicks in.
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.
The same could be said of temporary buydowns where you get a discounted rate in year one, two, or three, before the rate reverts to the higher note rate for the remainder of the loan term.
While you can save some money during the teaser rate period, be sure you can afford the actual interest rate once it goes away!
What Is a Teaser Rate?
- A short-term promotional interest rate that is lower than the note rate
- Examples include adjustable-rate mortgages (ARMs) and temporary buydowns
- Rate is fully-amortizing, but will increase once the teaser rate period ends
- Designed to lure borrowers into a certain loan program or home purchase
- Watch out for the initial rate adjustment and be sure you can afford the higher payment!
A common example is the 5/1 ARM, which comes with a teaser rate for the first five years of the mortgage term before becoming an annually adjustable-rate mortgage (ARM).
During those initial five years, you receive a “discount” for bearing the risk of a loan that will eventually become adjustable for the remaining 25 years.
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. You could also technically sell or refinance before that adjustment.
Many home equity lines also come with teaser rate specials, such as 1% below prime for the first year, 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 those old 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
- Banks, lenders, and home builders offer teaser rates to get borrowers in the door
- They can provide monthly payment relief initially but the low rate is only temporary
- You still have to qualify at the actual (higher) note rate and will be subject to higher payments eventually
- Be careful when considering a low rate that is only good for a few months or years
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%
Margin: 2.25
Teaser rate: 1% below prime for first 12 months
Focus on Your Actual Interest Rate When Deciding on a Loan!
- While a teaser rate may be tempting and save you some money, the benefit is short-lived
- Rising payments may require you to refinance your mortgage or even sell the home
- Consider how long you’ll keep the loan and/or the property before agreeing to the loan
- This will help you determine if a teaser rate is the way to go vs. a fixed-rate option
Using the example above, the actual interest rate on the HELOC is 6.75%, or prime plus the 2.25 margin. But for the first 12 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 fully amortizing.
However, within a few months your outstanding loan balance will be subject to a higher interest rate. So it might offer little actual savings as you accrue debt over time.
For example, if I take out a HELOC and only charge a few things early on, that lower rate only applies to my small balance. Then a year later once I’ve borrowed a lot more, the higher balance is subject to the actual rate.
So in this case it might be better to pay attention to the HELOC margin, which sets the price for the remaining loan term.
Teaser rates on hybrid ARMs can be more worthwhile since you get a discount on the full loan balance from the get-go.
In the case of a 3/1 or 5/1 ARM, you’ll get a discounted rate for the first three or five years before the actual 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.
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