Teaser loan

What is a teaser loan?

Teaser loans are adjustable-rate mortgages, or ARMs, that offer seemingly low introductory interest rates, or what lenders call teaser rates, to attract clients to switch to a new lender or to take out a new loan.

ARMs adjust after a certain period, such as the 5/1 ARM with a low rate for five years and adjusting each year after that. A true teaser loan offers an even lower rate for a short period, before adjusting to the normal ARM rate.

Deeper definition

While adjustable-rate mortgages are teaser loans themselves, some experts make a distinction between regular ARMs and those with a teaser rate.

Regular ARMs adjust after a set period, with five years being the most popular with lenders. The adjustment takes place after five years, based on a benchmark such as the prime rate, the one-year Treasury bill or Libor. Then, it adjusts every year, with a cap on how high or low it can go.

A teaser loan is an ARM with a deeply discounted rate for a month to a few months.

Taking on teaser loans means accepting the risk of possibly having the rates change in favor of the borrower or the lender. The risk is why ARMs offer low interest rates compared to fixed-rate mortgages.

To be sure, that’s why homebuyers are attracted to teaser loans. The interest rates are initially very low, but eventually increases after the teaser period ends.

This kind of loan is mostly used by low-income homebuyers, young people entering the workforce who have just started earning money and newly married couples wanting to buy a house of their own.

In addition to ARMs, many home equity lines of credit come with teaser rates. For example, they might be structured as the prime rate minus 2 percent for the first six months before adjusting to a higher rate.

Teaser loan example

The Federal Reserve Board and the Office of Thrift Supervision offered this example of a teaser loan.

The ARM in its example offered a teaser rate of 4 percent for the first year for a monthly payment of $954.83 and a 6 percent fully indexed rate of 6 percent for the second year for a loan payment of $1,192.63.

But what if the indexed rate in the second year goes to 7 percent. Then, the monthly payment would be $1,320.59. That’s a difference of $365.76 from the teaser rate.

Borrowers should understand how rates can adjust and whether they can afford the increase before taking on a loan.

Aside from teaser loans, find other mortgage loans being offered by banks, and determine which fits your budget the best.

 

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