Initial Interest Rate

What is 'Initial Interest Rate'

Initial interest rate is the introductory rate on an adjustable or floating rate loan.

BREAKING DOWN '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 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 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, 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 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. The most commonly used index 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 or one to three percent, to provide the borrower with the loan’s rate. The market rate plus a lender’s margin is known as the fully-indexed rate.

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.