By definition, a teaser loan, also called an adjustable rate mortgage loan, is where the interest is paid at a very low rate by the borrower, which eventually accelerates after a few years. The initial interest rates are artificial and temporary in nature.
Teaser Loan: How do they work?
The adjustable rate mortgage (ARM) requires a specific benchmark, such as a prime rate, a year treasury with constant maturity, or any other benchmarks. It also corresponds to the margin that is based on the credit score of the borrower. Hence, the benchmark combined with the spread is the interest rate charged on the loan. When ARM’s offer a discounted index rate, it is called ‘teaser rate’ (usually in the first year) thus, making them teaser loans.
An example:
To comprehend how teaser rates affect the borrower’s payment, let’s assume:
Bank A offers $100,000 ARM to Jack. The interest rate charges I prime plus at 5% and a cap of 10%. If the prime rate is at 3% then Jack’s interest would be 5 plus 3 and at 8% and makes the monthly payment at $733.77. Now say, the prime rate increases to 4% then the loans interest rate would increase to 9%, increasing the payment to $804.63
In most cases, the ARMs will have caps. It is the limit on how high or how low the interest rate can go in a year, quarter, month, and how much they are free to move as well. However, in some cases it might be that the interest rate will adjust only if it’s in the upwards trend, that means that the borrowers will be at no luck if the interest rates fall.
How it matters?
The concept of teaser loan is to acknowledge the risk that both lenders and borrowers will benefit if rates will favorably change. Thus, ARMs are complex to deal with. For this reason, borrower needs to read and understand the documents provided by the lenders. Borrowers need to be sure that they can handle the worst implications when forced to pay for high interest rates on mortgages. On the lenders end, they are obliged to disclose how high a monthly payment can go for the borrower.
Further Reading
- Teaser rates in conventional adjustable-rate mortgage (ARM) markets – link.springer.com [PDF]
- Causes of the financial crisis – www.tandfonline.com [PDF]
- Institutional disparities in the pricing of adjustable rate mortgage loans – link.springer.com [PDF]
- Evaluating the interest-rate risk of adjustable-rate mortgage loans – www.aresjournals.org [PDF]
- Mortgage product substitution and state anti-predatory lending laws: better loans and better borrowers? – link.springer.com [PDF]
- The economics of structured finance – www.aeaweb.org [PDF]
- Securitization: cause or remedy of the financial crisis? – papers.ssrn.com [PDF]
