What Is the Initial Interest Rate?

The initial interest rate, also known as the teaser rate or start rate, is the introductory rate on an adjustable or floating-rate loan. It is usually lower than most other interest rates and often stays consistent within a specific time frame.

Key Takeaways

  • Initial interest rate, also known as a teaser rate or start rate, refers to the opening rate of an adjustable-rate loan or ARM.
  • They are generally lower than rates offered on traditional, fixed-rate loans and are established using benchmark rates.
  • Borrowers use the rates for a variety of purposes, from making lower interest payments to selling the property to speculation.

Understanding the Initial Interest Rate

Initial interest rate refers to the opening rate of an adjustable-rate loan, or ARM. ARMs are offered with a wide range of terms. Typically, the initial rate is set below prevailing interest rates and remains constant for a period of six months to 10 years. At the end of the introductory period, the lender has the right to adjust the interest rate. The first adjustment is limited by an initial interest rate cap, and any subsequent adjustments are subject to periodic interest rate caps. A lifetime interest rate cap sets an upward limit on the interest rate over the entire life of the loan. The loan's minimum rate is determined by a rate floor.

The initial interest rate is generally lower than rates offered on traditional fixed-rate loans, and it is sometimes referred to as a teaser rate or start rate. This is attractive to several classes of borrowers. First are those who seek to make lower interest payments over the introductory period. Second, many borrowers plan to refinance or sell the property before the ARM is eligible for adjustment. Finally, there are borrowers willing to speculate that interest rates will decline during the initial period. In this final scenario, the lender still has the right to move the interest rate upward, but it may opt not to in order to retain the loan by offering the borrower less of an incentive to refinance.

How Are Initial Interest Rates Established?

Lenders set mortgage rates according to one or a handful of available third-party benchmark rates. One of these indexes is the one-year London Interbank Offered Rate, or LIBOR. This rate is an aggregation of rates from international markets and is published widely on a daily basis. Lenders must disclose their choice of index at the outset of the loan, and add a margin typically in the range of 1–3%, to provide the borrower with the loan's rate. The market rate plus a lender's margin is known as the fully-indexed rate.

As of December 2020, plans were in place to phase out the LIBOR system by 2023 and replace it with other benchmarks, such as the secured overnight financing rate (SOFR).

When setting the initial interest rate of an adjustable loan, lenders subtract a percentage from the index as a means of attracting borrowers in one of the classes listed above. In general, a loan with a shorter introductory period will have a lower and more attractive initial rate, since the lender can recover lost interest from that lower rate sooner than it would be able to after a longer initial period.

Example of Initial Interest Rates

Terms for an initial interest rate vary based on the tenure of a loan. For example, a one-year ARM has an initial interest rate for only one year, while a 5/1 ARM will have an initial interest rate for five years.