The average sale price of a home in the United States has been skyrocketing in recent years, making it harder for homebuyers to afford what some still believe is a hallmark of the American dream.
The St. Louis Federal Reserve reports that the average home price in the third quarter of 2021 was $453,300, a number that might make you wince. As for the future, the 22 housing experts surveyed during today’s Real Estate Forecast Summit hosted by the National Association of Realtors (NAR) forecasted a 5.7% home price increase in 2022.
With these higher prices in mind, today’s house hunters are looking for ways to make their payments more manageable as part of a monthly budget. One financial mortgage product that has the potential to help borrowers save in the near term is a teaser loan, such as the once-popular adjustable-rate mortgage (ARM). But experts warn it’s not a good financial move right now over a fixed rate product.
When rates are high, such as pre-pandemic levels, ARMs can make sense because their lower introductory rates give borrowers a lower monthly payment during the introductory period. But when rates are lower-than-usual, such as these pandemic-era record-low rates we are seeing, a fixed-rate mortgage makes more sense.
Here’s what you need to know.
What Is a Mortgage Teaser Loan and How Do They Work?
A teaser loan is a mortgage that starts with a lower interest rate. The fixed introductory rate is good for a set period of time, says Tabitha Mazzara, director of operations for mortgage lender MBANC. After that initial period, the mortgage becomes an adjustable-rate mortgage, or ARM, with a variable rate that fluctuates based on market conditions.
Teaser loans are structured based on the intervals at which interest rates incrementally increase. “For example, a 5/1 mortgage is fixed for the first five years,” Mazzara explains. “After that, the interest rate can be adjusted, according to the schedule provided when you initially take the loan. With a 5/1, the interest rate adjusts every year.”
It’s especially important to consider the introductory period of an adjustable-rate teaser loan, says Doug Perry, strategic financing advisor at Real Estate Bees, a real estate marketing firm. You’ll want to think about whether you can save enough interest within that time period to make it worth it.
Paying attention to the terms is an important part of preparing for the future, in case the interest rate adjustment moves higher. For instance, the 7/1 ARM is a longer teaser loan period that gives the borrower more time with a lower monthly payment — and more time to devise a strategy for either refinancing or affording potentially higher payments later.
When comparing teaser loans to other mortgage products, understand how often the rate on your teaser loan will adjust, plus whether there are caps on the interest rate. Many lenders cap the interest rate at a specific level. This helps you know that even if rates rise in the future, the rate on your loan won’t exceed the cap.
Are Adjustable Rate Mortgages Worth It?
In this current low-rate market, it doesn’t make sense to get a teaser loan, says Mazzara. In the wake of the economic pressures related to the COVID-19 pandemic, the Federal Reserve took steps to keep interest rates low. This makes it easier for households and businesses to borrow at an affordable rate. The downward pressure on rates positively impacts new borrowers by reducing the overall cost of a home.
“Right now it doesn’t make sense to take adjustable rate mortgages of any kind,” Mazzara says. “There are so many better alternatives available.” Your bank may offer different products designed to help consumers lock in lower rates for longer periods of time, including first-time homebuyer loans and VA loans.
With interest rates so low right now, consider locking in a fixed rate instead of getting a teaser loan.
“If you’re not getting any benefit but still shouldering the same amount of risk, why bother?,” he said.
With fixed mortgage rates so low right now, it’s probably not worth it to get an adjustable-rate mortgage through a teaser loan, even if on paper, it could save you a few dollars each month. “The difference in rate and payment can be made up with other types of programs that are more secure,” Mazzara says. “There are better options than to take these teaser mortgages, especially the shorter terms. That five-year mark comes up pretty fast.”
This is especially true if you plan to stay in the home longer than the introductory period, then In that case, a fixed rate will be less risky and maybe less costly in the long run.
If you do find a good teaser loan offer, you’ll want to carefully do the math and make sure you’re saving money where it counts. Fixed-rate mortgages could have slightly higher rates than their adjustable-rate counterparts, but over time you might come out ahead if interest rates rise. Meanwhile, some mortgage products allow you to pay interest-only for 10 years, and then convert that to a 30-year fixed loan at the same interest rate — thus locking you into predictable interest.
The Pros and Cons of an Adjustable Rate Mortgage
With any financial move, there are advantages and drawbacks to consider. Sometimes a teaser loan could make sense. Teaser loans can be worth it when homebuyers are comfortable with the risk and plan to refinance the loan down the road.
“As with any loan, it is important to understand all of the terms of the loan, especially how long the introductory rate is in effect so there aren’t any surprises when the rate adjusts,” Perry says. If you don’t refinance or sell the home before the introductory period is over, your new rate could likely be higher making a monthly mortgage payment higher if the new rate adjusts up.
Here are the pros and cons:
- Lower monthly payment at first: During the teaser rate period, you receive a lower monthly payment. This can make a home purchase more manageable at first.
- Potential to afford a bigger house: With a mortgage teaser loan, you can potentially afford a more expensive, bigger home. With a lower monthly payment, your debt-to-income ratio will be lower, leaving you room to get a larger loan.
- Pay less in interest at first: You can potentially pay less in interest with a lower rate. As long as you refinance before the interest rate starts to rise, you could potentially save money in the long run.
- Higher payments when the teaser term ends: Once the teaser rate ends, you could potentially see higher monthly payments if the interest rate adjusts up. If you haven’t planned for it, or don’t have the income to support higher payments, this could put strain on your monthly budget.
- Might not be able to refinance: One strategy with a teaser loan is to refinance before the initial period ends. However, if your circumstances change and you’re unable to refinance, you might not be able to avoid the increase in rates.
- Harder to plan your budget: During later parts of the mortgage term, you won’t always know what your payments will be. It can be harder to plan your budget if you’re not sure what to expect with your mortgage payment.
- A fixed-rate loan may be a better move, especially in the current low rate environment we are in right now.