A Guide To Teaser Rates: What They Are And How They Affect Your Mortgage
Dan Rafter7-minute read
June 25, 2021
You probably know that credit cards often offer short-term teaser interest rates to attract customers. These teaser rates usually last for a short period – often 6 – 12 months for credit cards – and can be as low as 0%. When the teaser period ends, though, that initial low rate adjusts to the credit card’s standard interest rate, one that’s often far higher. It’s not unusual for credit card teaser rates to shoot up from an APR of 0% to one of 20% or higher.
But did you know that lenders might also offer teaser rates on mortgage loans? And that these initial interest rates can be lower than the typical interest rates you usually get with home loans?
It’s true. But here’s the catch: A teaser rate might be attractive, but like all such rates, it’s only temporary. You need to be certain that you can afford your monthly mortgage payment if that initial rate adjusts and jumps to a higher one. If you can’t? You could end up missing mortgage payments and falling into foreclosure.
What Is A Teaser Rate?
Lenders have long used teaser rates to market their products to consumers. This is an especially common practice for banks and financial institutions: They’ll offer an APR that’s lower – often significantly so – than market rates for a limited time on their credit cards as a way to entice consumers to apply for them.
Teaser rates aren’t quite as common with mortgage loans. For most mortgages, the rate you get when you close your loan is the same one you’ll have until you sell your residence or refinance your mortgage.
There is an exception, though: adjustable-rate mortgages, otherwise known as ARMs. These mortgages feature a low initial interest rate – the teaser rate – for a set number of years before they adjust to a sometimes higher interest rate after this introduction period ends.
Understanding Teaser Rates On Home Loans
There is some disagreement on whether the initial interest rates that come with adjustable-rate mortgages are actually teaser rates in the traditional sense.
A standard ARM comes with a fixed period and an adjustable one. During the fixed period, the loan has an interest rate that is typically lower than what borrowers would get with more common fixed-rate loans. This rate will remain in place for however many years the fixed period lasts, usually 5 or 7.
After the fixed period ends, the interest rate on the loan adjusts, often once every 6 months to a year, depending on whatever economic index the loan is tied to. In many cases, the interest rate will increase during the adjustment period, something that will also cause borrowers’ monthly payments to rise.
Many consider ARMs an example of teaser rates because of this: That first fixed period, when the interest rate is lower, is a type of teaser rate to encourage people to apply for ARMs.
There is another type of teaser rate for ARMs though, one that is less common. Some lenders might offer an even lower initial interest rate with an ARM, one that lasts only 1 or 2 months. The loan’s fixed interest rate – still lower than what you’d get with a fixed-rate mortgage – would then kick in after the teaser period ends. And that new rate would adjust one more time once the fixed period ends and the loan enters its adjustable period.
These teaser rates are used primarily to entice consumers, much like credit card providers offer 0% interest on new purchases or balance transfers for a limited time. Rocket Mortgage® conventional ARMs adjust twice per year after the fixed period expires.
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An Example Of Teaser Mortgage Rates
How do ARMs and teaser rates work?
Say you take out a 5/1 ARM of $300,000 for a 30-year term. This means that your interest rate will remain fixed for the first 5 years of the loan and then adjust every year for the last 25 years of the loan.
Your initial teaser rate, the rate that is in place for the first 5 years of your loan, might be lower than market rate. Say your interest rate for the first 5 years is 3%. Maybe if you took out a standard 30-year fixed-rate mortgage your interest rate for the entire loan would have been 3.8%.
During the first 5 years of your ARM, you'll have a monthly payment, not including what you pay for property taxes and homeowners' insurance, of $1,264. If you had taken out that standard 30-year fixed-rate loan, your monthly payment during those first 5 years, again without taxes or insurance, would be $1,397.
That's a difference of $133 a month. During the first 5 years, then, you would have paid $7,980 more in total with the 30-year fixed-rate loan than you would have with an ARM.
Things will change after year 5 though, and this is where the risks of an ARM come in, even with that low initial teaser rate. Starting in year 6, your loan's interest rate will adjust according to whatever economic index it is tied to. In most cases, your interest rate and your monthly payment will go up.
Depending on what is happening in the economy and with interest rates, your new monthly payment now might be higher than what your monthly payment would have been starting in year 6 if you had taken out a 30-year fixed-rate loan. Or it might not be. You have no way of knowing.
But say your interest jumps enough so that your new monthly payment on your 5/1 ARM, not including taxes and insurance, now rises to $1,450. That is now $53 more a month than what you would have been paying with that fixed-rate loan. That's $636 more a year, which can add up if you take the full 30 years to pay off your 5/1 ARM.
There is a caveat here, though. Many homeowners take out an ARM and then refinance to a standard fixed-rate loan before they hit their ARM's adjustment period. This way, they can take advantage of the low initial teaser rate of an ARM and then get the benefits of a stable monthly payment once they refinance to a fixed-rate loan.
Just be aware: You'll generally need at least 20% equity to qualify for a refinance. Equity is the difference between what you owe on your mortgage and what your home is worth. If your home is worth $200,000 and you owe $100,000 on your mortgage, you have $100,000 in equity. If your home's value does not rise much or at all during your ARM's fixed-rate period, you might not have earned enough equity to refinance.
Is an adjustable-rate mortgage with a teaser rate a good idea? That depends:
- How long do you plan on living in your home? If you don’t plan on staying for more than 5 or 7 years, an ARM with a low teaser rate could save you money. If you sell your home before the teaser rate expires, you won’t have to worry about the higher monthly mortgage payments that will kick in once your loan enters its adjustment period.
- Teaser rates may persuade you to purchase more home than you can actually afford. Why? The low initial rates will give you a monthly mortgage payment that is artificially low for the home you are buying. You might be able to afford these payments. But what happens when your interest rate adjusts and your mortgage payment rises? You might not be able to afford these newer monthly payments.
- While a low teaser rate might give you a lower monthly payment for 5 or 7 years, you might end up losing money over the remaining 25 years of your 30-year ARM. Maybe when you first took out your mortgage, the average interest rate on 30-year fixed-rate loans stood at 3.5%. But what if five years later when your loan enters the adjustment period, the average rate on 30-year fixed-rate loans has risen to 4%? You might now be stuck with a higher interest rate for the majority of your loan’s life span because you didn’t choose a 30-year fixed-rate loan at a lower rate – a rate that doesn’t change – 5 years ago. If you take the full 30 years to pay off this loan, you’ll end up paying more than you would have if you had taken out a 30-year fixed-rate loan 5 years ago.
Are Teaser Rates A Good Idea?
Teaser rates can make financial sense. Maybe you are struggling to pay off thousands of dollars in credit card debt. If you apply for a new credit card that comes with a teaser period offering 0% interest on balance transfers for 12 months, you can transfer your existing debt to this new card and pay it off without worrying about paying interest, as long as you pay off that debt before the teaser period ends.
Teaser rates are more complicated when it comes to mortgage loans. You can save money with an ARM that comes with a 5-year or 7-year teaser period. But you must make sure that you can afford the higher monthly payments that come when your ARM enters its adjustable period if your interest rate rises.
If your plan is to sell your home or refinance your mortgage before your ARM enters its adjustable period, know that you are taking on some risk. If home prices fall after you buy your residence, you might not have enough equity to refinance. And what if the housing market slumps and you can’t sell your home? You’re also taking a risk that interest rates on a standard fixed-rate mortgage won’t be too much higher than they are when you take out your ARM.
A good move might be to make sure that your credit score is high enough so that you qualify for the lowest possible interest rates on any mortgage loan. What are the most important tips to get the best mortgage rate without opting for a teaser rate mortgage? Pay all your monthly bills on time, pay down as much of your credit card debt as you can and keep paid-off credit card accounts open, even if you plan on never using that card again.
The Bottom Line
An ARM with a low teaser rate can be a smart financial move. That low initial interest rate can lower your monthly mortgage payments, at least until your ARM enters its adjustable period. Just be aware: Your monthly mortgage payment could rise significantly depending on market conditions during your loan’s adjustable years.
You can use our site to compare adjustable- and fixed-rate mortgages if you need help finding the home loan that best fits your needs.
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