Teaser Rates In Depth

Teaser rates are typically used as a hook to catch new business. (Although they also have a useful purpose we'll discuss below)  They entail a big discounted rate up front and usually a higher than normal rate on the back end.

Teaser rates don't suck in as many people as they once did.  The Internet is educating more borrowers and people are doing the math on their own.  As a result, a teaser rate of 1.50% below prime for six months doesn't catch as many fish as it used to.

Consider the numbers.  Suppose you get a 5-year variable rate at 1.50% off prime for six months, and prime minus 0.25% thereafter.  That equates to an effective rate of roughly 5.38% given today's prime rate of 5.75%.

Instead, you could go to any of 15+ lenders and get prime - 1/2% (i.e.  5.25%) or better.  That's a $1565 interest savings on a $250,000 five-year mortgage amortized over 25-years.

The moral is, if you're considering a teaser rate, ask your mortgage planner or lender about the effective rate.  That'll let you compare apples to apples when evaluating other variable-rate deals out there. 

In general, you'll find that regular discounted rates are better than effective teaser rates.

As noted above, however, there is one strategy where teaser rates make sense.  If you wanted to eventually lock into a fixed rate, but felt strongly that rates would fall (as most do today), you could get a teaser rate for 6-12 months.  If fixed rates fell, you could then lock in.  The benefit is that you'd pay less interest than a regular variable rate mortgage while you're waiting.

If you do use this strategy, it's critical that you choose a variable rate mortgage with an excellent conversion rate policy.  In other words, the lender should let you convert into a fixed rate that's near the lowest fixed rate you can get at the time.  Otherwise, you might as well avoid the interest rate risk and get a low fixed rate right from the start.

Keep two more things in mind:

1.  You'll rarely get a better fixed rate at conversion than you would if you got a brand new fixed rate mortgage.  The best fixed rates will usually be at another lender, or be promotional rates that apply only to "new business."

2.  Timing the credit market and predicting interest rates (beyond a few months) are big gambles.