There are a few different uses for the so called “teaser rate”.
A teaser rate is usually a lower interest rate that is used to attract potential buyers who may or may not qualify for that lower rate.
In some cases teaser rates are the initial interest rate offered for the loan, but at some point this rate will begin to escalate and move higher. Teaser rates are often used to attract buyers who may be diverted into loans that are easier to qualify for, but are more expensive over the life of the loan. Either way, teaser rates are designed to “tease” buyers with an offer that looks good on the surface, but the rate will escalate at some point in the future.
Teaser rates will refer to several different phenomena in the mortgage industry.
The purest and most harmless definition of a teaser rate is when a legitimate 2nd lien lender offers an “ introductory rate,” much in the same way a credit card might offer a 0% special for a certain intro period. Many home equity lenders have offered intro rates on their HELOCs if the borrowers agree to a minimally higher rate over the life of the loan. Some lenders simply offer the intro rate with no “catch.” In that case, it’s just a selling feature.
The more harmful construction of “teaser” has come (inaccurately) to refer to the low initial rate on an adjustable rate mortgage, or ARM. ARM’s start at a certain rate and then adjust to a different rate based on the margin and the index. If the margin plus the index yields a lower number than the initial rate, then the rate will actually go down. Unfortunately, most of these ARM’s are structured such that the rate will adjust upward, especially if the market is the same or higher than when the loan was originally obtained. These loans were originated unscrupulously in some cases and borrowers were essentially “teased” with an unrealistic expectation of what their rate would be. Again, this IS NOT the actual definition of “teaser” rate, but has become almost more of an accepted definition because of the mortgage crisis.
In the case of certain types of ARMS called Option Arms, the payment schedule is structured such that the payment increases by 7.5% per year for the first five years and then re-adjusts based on the current value of the home. These option ARMs were very popular recently and in many cases, the initial, lowest possible payment was pitched as “the payment” without regard to the increased payments in the future. Even though the 7.5% increase was disclosed in many cases, borrowers emotionally made the decision to get the loan because the first year’s payments were so low.
Another semi-innocuous form of a teaser rate is the more-or-less legitimate 2-1 buydown. It’s a loan that ethical mortgage brokers can actually use to good effect depending on the situation. Basically, it allows a borrower to obtain a 30 year fixed mortgage at a slightly higher rate than a conventional 30 year fixed. In exchange for this slightly higher rate, their initial rate will be 2% lower for the first year, 1% lower for the next year, and the at level note rate thereafter. For instance, a 2-1 buydown loan with a note rate of 6.75% would be at 4.75% the first year, 5.75% the second year and 6.75% thereafter.
As you can see, a teaser rate can be a good thing or a bad thing, but the incredibly negative stigma it has adopted has come from recent mortgage troubles with ARMS.