What is a Teaser Rate?
A teaser rate is usually an artificially low initial interest rate on an adjustable-rate mortgage (ARM).
How Does a Teaser Rate Work?
The interest rate on the ARM corresponds to a specific benchmark (often the prime rate, but sometimes LIBOR, the one-year constant-maturity Treasury, or other benchmarks) plus an additional spread (which is also called the margin, and its size is often based on the borrower's credit score). The benchmark plus the spread equals the interest rate on the loan; it is called the fully indexed rate. Some ARMs offer a discounted index rate, also called a teaser rate, during the first year or so.
To understand how adjustable interest rates affect a borrower's payment, let's assume that a bank offers a $100,000 ARM to a potential borrower. The interest rate is prime plus 5% with a cap of 10%. If the prime rate is 3%, then the borrower's interest rate is 8% (5% + 3%), and the monthly payment is $733.77. If the prime rate increases to, say, 4%, then the loan's interest rate goes to 9% (5% + 4%), and the payment goes to $804.63.
In many cases, ARMs have caps: limits on how high (and sometimes how low) the interest rate can go, and how much they can move in any one year, month or quarter. In some cases, the interest rate will only adjust upward -- that is, borrowers will get no benefit if interest rates fall.
Why Does a Teaser Rate Matter?
The idea behind ARMs is to accept the risk (and the corresponding potential reward) that rates will change favorably and thus benefit the borrower or the lender. For example, if a borrower takes a ARM that currently carries a 7% interest rate, he is hoping that rates will drop and his payments will fall accordingly; the lender, on the other hand, is hoping that interest rates will increase, which raises the amount of profit the loan generates (by increasing the borrower's payments). Because of this risk arrangement, ARMs often carry lower interest rates than fixed-rate mortgages, which in turn might allow borrowers to borrow more than they could under fixed-rate mortgages. A teaser rate often exacerbates this issue.
As you can see, ARMs can have complex implications. Thus, as is the case with any mortgage or other loan, borrowers must be sure to read and understand the lender's documentation and contemplate the implications of changes in interest rates. Borrowers should be sure they can handle the worst-case scenario of being forced to make the highest mortgage payments allowed. Lenders are legally required to disclose how high the borrower's monthly payment might go.