When mortgage lenders fund fixed home loans, they risk losing money if interest rates rise — if they are getting four percent for 30 years, but market rates have risen to eight percent, those loans could be costing lenders money every month. The lower current 30 year fixed rates are, the more likely it is that they will increase in the next few years.
In order to shift some of this interest rate risk onto borrowers, lenders offer adjustable rate mortgages with rates that can increase when market rates rise and decrease when they fall. Of course, few borrowers would be interested in taking on extra risk unless they got something in return. That’s where the discount comes in — it’s called a “teaser” rate or start rate and it’s considerably lower than 30 year mortgage rates and 20 year fixed rates. In July of 2014, for example, the 30 year fixed rate (pulled from LendingTree’s LoanExplorer tool) was 3.958 percent (APR) and the 3/1 ARM had an APR of just 2.562 percent. That start or teaser rate is fixed for three years and then it adjusts (resets) at regular intervals until it’s paid off or refinanced. With a $300,000 mortgage, the 3/1 payment is $225 a month less than the 30 year fixed payment.
ARM teasers rates can be fixed for periods as short as one month to periods as long as ten years.