Teaser Rates: What You Should Know

While most mortgage borrowers choose a fixed-rate mortgage to finance or refinance their home, a teaser rate tempts some borrowers. A loan with a teaser rate can be an advertising tool to attract borrowers to a lender. After the period with the teaser rate ends, borrowers pay a higher interest rate on the loan. Borrowers who prefer a consistent interest rate for the entire loan term may want to pick a fixed-rate loan. If you want to consider a mortgage with a teaser, read more to understand how they work.

What is a teaser rate?

A teaser rate is a loan that starts with a lower rate and converts to the full interest rate when the teaser rate period ends. A teaser rate is also called an introductory rate, a starter rate or a discount rate, according to the Consumer Financial Protection Bureau. In some cases, a teaser rate is an advertised mortgage rate that is only available to borrowers who meet specific qualifications, such as a very high FICO credit score or making a large down payment.

Teaser rates can also refer to variable rates that may rise from the beginning of the loan period to a higher rate later during the loan term. These variable rates are found in certain types of home loans, including adjustable rate mortgages (ARMs) and home equity lines of credit (HELOCs). Some credit cards include teaser rates to entice new customers or to encourage a balance transfer.

How does a mortgage teaser rate work?

If you see an ad for a mortgage rate that’s well below the interest rates offered by other lenders, you may want to carefully compare the terms. A lender that offers a teaser rate of 1.99%, for example, may be providing that only to a handful of borrowers who meet certain qualifications such as making a down payment of 25%.

A true teaser rate on a HELOC may be offered for six to 12 months and then rise to a rate that’s specified upfront or tied to market rates. After the rate increases, your payments would rise. Many HELOCs allow borrowers to make interest-only payments for the first 10 years of the loan. For example, the monthly payments on a $50,000 HELOC balance at 1.8% would be just $75 for the first six months, then jump to $180 for the first 10 years at a rate of 4.3%, followed by $377 for the following 15 years.

Teaser rates are mostly available on adjustable-rate mortgages and HELOCs.

Teaser rates for adjustable-rate mortgages

An adjustable-rate mortgage (ARM) has a variable interest rate that changes according to the terms of the loan. ARMs typically have a fixed period of one month to 10 years, an adjustment period that can be every few months, annually or every three or five years; an index that the rate is tied to and a margin that indicates the points the lender can add to the index. ARMs also usually have a cap to limit rate adjustments. Since an ARM has established terms for adjusting, it’s not exactly a teaser rate.

For example, if you choose a 30-year 5/1 ARM for $250,000 that has caps of 2/2/5, that means your rate can rise by a maximum of 2% at the first adjustment and each subsequent adjustment and can never be higher than 5% of your initial rate. If your initial rate is 3%, your monthly payment would be $1,054 for the first five years. In year six, your rate could rise to 5% and your payment would be $1,300. The maximum rate would be 8% and your maximum principal and interest payments would be $1,698. However, your rates depend on the index and market rates, so it’s possible your payments won’t rise for a while and could even decline.

Teaser rates for HELOCs

A HELOC is a line of credit against the equity in your home that works like a credit card. You can borrow up to the limit, repay the money and it becomes available again. Typically, HELOCs have a variable interest rate and some include a teaser rate for the first six to 12 months. Most HELOCs have a 10-year “draw period” when you can access the funds and then a 15 to 20-year repayment period. Many lenders allow you to make an interest-only payment during the draw period and then full payments are required during the repayment period.

Mortgage teaser rate pros and cons

Teaser rate mortgages carry more risk and uncertainty than fixed-rate loans because of the unpredictability of interest rates. The decision about a mortgage with a teaser rate depends on your situation.

Pros

  You can free up funds to pay off high-interest debt: During the introductory rate period, you can use the extra cash flow from lower payments to pay off other debt and to make it easier to make higher payments when your loan adjusts.

  You have the flexibility to sell before the fixed-rate period ends: If you plan to sell your property before the first rate adjustment, then a teaser rate might be attractive. However, plans sometimes change or it may take longer than expected to sell your property and you could be stuck with higher payments after the teaser rate ends.

  You can plan to refinance near the end of the teaser rate: A plan to refinance into a fixed-rate loan may work, but you typically need at least 3% in home equity to refinance and a good credit score. If home values have dropped, mortgage rates are higher or your creditworthiness has declined, you may not be able to refinance.

Cons

  You may end up paying more interest over the duration of the mortgage: A fixed-rate loan at a low rate for 30 years can result in lower interest paid overall. For example, you’ll pay $129,444 in interest on a 30-year fixed-rate loan at 3%, compared to $189,415 over 30 years with a 5/1 ARM that starts at 2.5% and then adjusts 0.25% annually after the first five years.

  You may purchase more home than you can afford: If you’re stretching to make the smaller payments in the initial phase of an ARM, it could mean you’re overspending on housing. Calculate your highest possible payment to see if you can afford it.

  Your interest rate could dramatically increase over time: Locking in low rates with a fixed-rate loan makes sense when rates are low. A variable rate is likely to rise in the future and increase your payments, however.

Alternatives to a teaser rate

If you prefer to avoid the risk of a teaser rate, you may want to consider the following ways to get a better mortgage rate.

→ Improve your credit score. The lowest mortgage rates are available to borrowers with a credit score of 740 or higher. A higher score may also reduce your private mortgage insurance premiums. To improve your credit score, pay your bills on time and pay down debt.

→ Make a larger down payment: A larger down payment means your loan-to-value is lower, which may reduce your interest rate. The higher your loan-to-value, the higher your interest rate in most cases.

→ Buy down your rate with points. If you have extra cash, you can buy down your rate by one-eighth (0.125%) to a quarter (0.25%) per discount point. A discount point is equal to 1% of your loan amount.

→ Refinance your mortgage. If you already have a loan, you may qualify to refinance into a lower rate. You’ll usually need a minimum of 3% in equity to refinance and must meet other lender requirements, such as a minimum 580 to 620 credit score. However, you may need a higher score and more equity to qualify for the lowest rates.

Should you consider a mortgage teaser rate?

If you’re thinking about applying for a mortgage that starts with a teaser rate, you should be certain that you fully understand the terms of the loan. In addition, you’ll need to reflect on your housing plans and financial outlook. When you consider a mortgage teaser rate, some of the factors you should evaluate include:

How long is the teaser rate period? A short teaser rate period may not have much of an impact on how much you can save with the mortgage if it only applies to a few payments. However, a loan with a longer initial period such as five or seven years, may have a higher teaser rate. You’ll need to compare the full terms of each loan to understand the potential savings.

How large is your loan? Your interest rate will have a bigger impact on your payment if your loan balance is larger. A teaser rate on a relatively small loan may not save as much as you think.

What are your plans for the property? If you know you will sell the property to relocate before the teaser rate resets, it could make sense to save on interest during the loan period. Still, it’s wise to calculate the worst-case scenario for payments after the teaser rate ends just in case your plans change.

What will the rate and payment be after the loan resets? Your rate will fluctuate according to the terms of the loan after the teaser rate ends. While the rate depends on several factors, you should calculate the highest it could be so you can evaluate whether you would be comfortable with that payment amount.

Is there an upcoming change in your finances that could make it easier to afford a higher payment when the teaser rate ends? If you’re sure of a windfall or a big commission that you could use to pay down the loan balance or make higher payments, a teaser rate could make sense. Similarly, if you expect an increase in your income because you’ll finish a medical or law school program or if you’ll pay off a lump sum of debt — such as a student loan balance — before the teaser rate ends, that could be another reason to consider this loan type.

Have you calculated the full interest you’ll pay over time? A mortgage calculator can help you compare loans with a complete analysis of how much interest you’ll pay on the entire loan balance under different scenarios, which could influence your decision about applying for a teaser rate mortgage.