What are mortgage teaser rates? Teaser rates explained

Peter Warden
The Mortgage Reports editor

What is a mortgage teaser rate?

A teaser rate is a marketing device used by lenders to attract borrowers. You get a low introductory interest rate that later jumps to or above the market rate.

Most homeowners choose a fixed-rate mortgage. With these, you don’t have to worry about teaser rates because your interest rate is fixed for the life of the loan.

But if you want a home loan with a variable rate — like an adjustable-rate mortgage or HELOC — you’ll want to understand how mortgage teaser rates work.

Check your mortgage interest rates. Start here (Jul 31st, 2021)

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Mortgage teaser rates explained

If you’ve ever seen offers for 0% APR credit cards, you’re already familiar with the concept of teaser rates. You pay zero interest on the plastic for a set period of time. And then a much higher rate kicks in.

But what does this have to do with mortgages?

Mortgage loans with teaser rates

Mortgage teaser rates can crop up with an adjustable-rate mortgage (ARM) or home equity line of credit (HELOC) — a form of the second mortgage.

These loan types have ‘variable rates,’ meaning lenders are able to offer a lower (teaser) introductory rate which can eventually adjust upward.

However, you’re much less likely to encounter mortgage teaser rates today than in the past. They were a part of the irresponsible lending that led to the 2007-08 credit crunch. So consumers, lenders, and regulators in the mortgage industry are keen to avoid the worst types of offers seen back then.

ARM loans typically still advertise lower initial rates than fixed home loans. But the introductory or ‘teaser’ rate may not be as artificially low as you would have seen in the past.

Fixed-rate mortgages

If you want a standard, fixed-rate mortgage (FRM), you don’t have to worry about these teasers at all.

Yes, some lenders will advertise low rates on FRMs that you can only get if you buy discount points at closing. And some ultra-low rates you’ll see advertised are only available to those with pristine credit and 20% down.

But those aren’t teaser rates in the usual sense; if you do qualify for that ultra-low fixed rate, you keep to keep it for the long haul.

Check your mortgage interest rates. Start here (Jul 31st, 2021)

What happens when the teaser rate expires?

When the teaser rate on an ARM or HELOC expires, your mortgage interest rate can change. If interest rates have increased since you opened the loan, your mortgage rate — and monthly payment — could rise.

Exactly how high your new rate will be will depends on the broader interest rate market.

That’s because ARM and HELOC rates are typically tied to external rate indexes, often the one published daily in The Wall Street Journal. That’s called the WSJ current prime rate index. But there are many others. And your mortgage agreement will specify which index yours is tied to.

Of course, your rate will be considerably higher than that prime rate. Because your loan is much riskier than those made to the big banks and huge multinationals that really do get to borrow for next to nothing.

To make up for that extra risk, a “margin” will be added to the prime rate and that margin plus the prime rate is what you’ll pay. But your ARM or HELOC rate will go up or down in line with its chosen index.

How ARM loans work

Mortgage borrowers are most likely to encounter teaser rates when shopping for adjustable-rate mortgages. So it’s important to understand how those ARM rates work.

ARMs come in several flavors, including 1/1, 2/1, 3/1, 5/1, 7/1, and 10/1.

The first number indicates the number of years the fixed, introductory rate lasts. After that, your rate will float in line with wider interest rates.

It’s worth noting that the shorter the time your rate is fixed, the lower that initial rate will be. (For instance, a 5/1 ARM should have a lower intro rate than a 10/1 ARM.)

The second number (the ‘1’) tells you how often your rate can be reset after the introductory fixed rate ends. A ‘1’ means it can float up or down once every year.

Of course, if you’re sure you’re going to move before the low fixed rate expires, you can safely get an ARM and never face a rate hike. You’ll have a new mortgage by the time the introductory period is up. However, note that average mortgage rates might be much higher when you take out your next loan.

Adjustable rate caps

Nowadays, ARMs and HELOCs often come with rate caps. And you need to scour your mortgage offer (‘Loan Estimate‘) to make sure:

  1. It contains rate caps — Not all do
  2. Those caps provide an adequate level of protection against sudden, sharp rate rises

These caps often apply in three ways. They specify the maximum amount your rate can rise:

  1. The first time your rate adjusts (when the initial, fixed-rate period ends)
  2. Each time a rate review is allowed (usually once per year)
  3. Overall: Your rate can never rise above x%

You need to model a worst-case scenario to tell you how much your rate and loan payments could increase if interest rates shoot higher.

This exercise used to feel theoretical. But the aftermath of the COVID-19 pandemic has made significantly higher rates a real possibility.

So check page 2 of the Loan Estimates you receive from lenders. Each shows an Adjustable Interest Rate (AIR) Table, which lays out your caps and other information.

Learn as much as you can

Make sure you’re 100% clear about your exposure to higher rates. And, by all means, consult an independent professional and read more widely.

Financial regulator the Consumer Financial Protection Bureau publishes an excellent booklet called the Consumer Handbook on Adjustable Rate Mortgages.

Perhaps the most important piece of advice that booklet contains is:

“Some lenders offer a “teaser,” “start,” or “discounted” rate that is lower than their fully indexed rate. When the teaser rate ends, your loan takes on the fully indexed rate.

“Don’t assume that a loan with a teaser rate is a good one for you. Not everyone’s budget can accommodate a higher payment.”

Can a teaser rate save you money?

You bet! Those who have taken ARMs over the last decade or so have generally seen savings. In some cases, their mortgage loan rates have actually fallen in line with other interest rates. And they’ve been spared the expense of refinancing in order to access the lowest mortgage rates.

Leaving aside teasers, ARM rates are typically noticeably lower than those for fixed-rate loans. So many would-be homeowners see ARMs as a quick and inexpensive way to get onto the homeownership ladder.

That’s because the borrower is shouldering some of the risk of rising rates. With fixed-rate products, the lender carries all that risk — usually for up to 30 years.

But are the good times over? Many expect the end of the pandemic to bring an economic boom. And those almost always bring significantly higher interest rates.

Where will those rates be after the five or seven years of a 5/1 or 7/1 ARM? What impact will a higher monthly mortgage payment have on your household budget?

As we said, consider all the pros and cons of an ARM loan before signing on.

What are today’s mortgage rates?

It’s almost certain that ARMs will continue to have lower rates than FRMs. So home buyers who use them strategically (and move or refinance before the fixed-rate introductory period ends) should still see savings on their mortgage payments.

However, it’s debatable whether the math still works as favorably when you add in closing costs for refinances and those plus moving expenses for changing homes.

Keep in mind, low interest rates are the norm across all types of loans right now.

Borrowers with a solid credit score and down payment can typically get a great deal in today’s mortgage market — without taking on the risks of an adjustable-rate loan.

Check with a few mortgage lenders to see what kind of deal you’re in line for. You might find you can secure a low interest rate and monthly payment without choosing a teaser rate.

Verify your new rate (Jul 31st, 2021)