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A Teaser Rate: Is that low interest rate too good to be true?

teaser rate

So-called teaser rates were once regularly used to attract borrowers to take out adjustable-rate mortgages, but they don’t exist anymore as a common loan product, according to Tendayi Kapfidze, chief economist at LendingTree.

“Teaser rates … created havoc during the financial crisis,” he said. “They have disappeared as mainstream products, though they may be available as bespoke products to high net worth individuals.”

These days when you hear the term “teaser rate” you’re more likely talking about the advertised mortgage rate lenders may splash across their website or advertise on billboards. Although mortgage rates are still historically low, there’s no getting around the fact that they have been steadily increasing.

By advertising rock-bottom mortgage rates, lenders have one goal in mind.

“The rates that are advertised — they’re really designed to get the phone to ring,” said Bryan Kelly, vice president of mortgage lending at Guaranteed Rate in Chicago.

Before you get to excited about advertised rates, let’s talk about how they really work.

Advertised rates on mortgages can be misleading because the rate can be entirely different by the time you pick up the phone or hop online to get a quote from the lender. Rates change daily or even by the hour sometimes.

Even then, the lowest rates advertised may only apply to borrowers with the best credit profiles or borrowers who can meet other requirements, like a specific down payment or those who are taking out a specific type of mortgage loan product.

As lenders talk with prospective borrowers and realize they don’t fit into each category perfectly, the advertised rate can easily inch upward.

“Most borrowers see advertised rates that can vary from what a borrower ultimately receives, making it important to shop around for better rates, even after receiving a firm offer,” Kapfidze said.

Teaser rates and adjustable-rate mortgages (ARMs)

It’s true that adjustable-rate mortgages have introductory interest rates that last for a designated length of time before changing. For example, a 5/1 adjustable-rate mortgage will carry a fixed rate for the first five years. These aren’t considered teaser rates, however, because these rates are standardized.

Adjustable-rate mortgages can pose a risk because after the introductory period, the rate can change every year over the course of the mortgage. For example, if someone had a 5/1 adjustable-rate mortgage, they would still have a monthly payment based on a 30-year loan. But the interest rate is only protected for the first five years. Starting with year six, the rate can adjust annually.

This is where borrowers can run into trouble. If rates are rising when their ARM ends, their mortgage payment could increase significantly.

However, ARMs can work in situations in which homeowners know they will not be in their home once the fixed rate ends. For example, Kelly said someone who is comparing a 30-year fixed loan and a 10-year ARM might consider the ARM if they’re confident they won’t be in their home in 10 years.

“Sometimes people think an adjustable-rate mortgage is a really dangerous thing and not right for them,” he said. “And I understand that. But sometimes, it makes sense.”

Builder buy-down rates

The term builder buy-down if often advertised as a way to get a low introductory interest rate on a newly built home. As an incentive to purchase a newly built property, developers will pay the lender the difference in a lower mortgage rate in exchange for a borrower purchasing a property. Demond Johnson, sales manager at Guild Mortgage in Arlington, Texas, said the numbers in front of the buy-down — i.e. 3-2-1 builder buy-down — signify how many years you’ll see the buy-down, with each number representing the amount of the buy-down from the normal rate.

“A 3-2-1 buy-down would mean that if your rate is 5%, subtract 3% in the first year, subtract 2% in the second year and subtract 1% in the third year,” Johnson said. “And the fourth year, you’ve got a 5% rate.” In this example, the property developer would likely be paying the lender the difference in the lowered interest rate for the first three years.

Johnson clarified that the difference between buy-downs and other promotional rates is that borrowers are still qualified on the higher rate. In the above example, the borrower would be qualified based on the 5% rate, not the 2% introductory rate.

“Underwriting will qualify you on the actual note rate,” Johnson said. “That will give you the ability of growing into the payment a little bit. But your income will have had to be qualified based on the higher rate.”

How to get the best rate on your mortgage

Improve your credit. People with credit scores in the high 700s tend to get the best mortgage rates. Get your free credit score from My LendingTree and track your progress.

Come with a large down payment. The bigger your down payment, the lower your mortgage rate will likely be.

Compare rates from more than one lender. In today’s environment of rising rates, it’s even more important to shop and compare loan offers from multiple lenders. Each week, LendingTree analyzes the spread between the lowest and highest rates offered to borrowers in our network. In the most recent report, we found a difference of 65 basis points between the lowest and highest rates offered. It may not sound like much, but on a 30-year fixed rate loan, that could translate to $30,473 in savings.

Other mortgage rate terms to be aware of

Origination fees

In addition, there are certain terms borrowers should be aware of come closing. Johnson said to pay attention to origination fees — the amount charged by the lender to process the loan — when shopping for a mortgage.

He said that in some states, charging a 1% origination fee is standard. But when lenders charge a 1% origination fee, “they’re able to suppress the rate of the loan more and keep it a bit lower because they’re making a good chunk of their income upfront,” Johnson said.

Borrowers might see a rate that is lower, Johnson added, but in reality, they’re not saving anything because they’re paying more in origination fees.

PMI

In addition, Kelly always advised clients to pay attention to how they pay their private mortgage insurance (PMI). This is something borrowers incur when they put down less than 20% upfront. Kelly said lenders often don’t go into detail about how borrowers can pay their PMI.

Most people pay PMI monthly as part of their mortgage payment, as it’s the default option given by most lenders. Some lenders may allow you to pay a one-time fee at the closing table called single-premium PMI, Kelly said. “Like anything in life, if you pay with a lump sum at the closing table, it’s more than likely that in most instances, it’s going to be significantly cheaper than if you finance it and pay it monthly for many, many years,” he added.

PMI can be canceled, however, if your home appreciates in value, or you gain enough equity to achieve a loan-to-value ratio of 78% or more.

Should you take a teaser rate or adjustable-rate mortgage?

As Kapfidze said, teaser rates used to be common in adjustable-rate mortgage products, but that is no longer the case.

Today’s ARMs feature fixed rates for a set number of years and after that time passes, the rate will change annually.

It depends entirely on a borrower’s specific financial situation whether an ARM is right for you. Consider how long you’ll stay in the home and if you are willing to risk getting stuck with a higher rate down the line. What matters most is doing your due diligence. Take a look at mortgage rate forecasts, and ask your prospective lender as many questions as possible.

 

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