About two weeks ago a reader emailed me asking whether he should sign up for a ‘teaser’ rate mortgage. The mortgage is a limited time offer and he wanted to know if the savings (compared to a traditional fixed rate mortgage) would be worth it.
Teaser Rate Mortgages
A mortgage ‘teaser’ or introductory rate is a regular mortgage that offers a significantly lower rate for a small amount of time in the beginning (the introductory period). Once this period ends, the regular rate kicks in that’s usually higher than current market rates.
Related: Mortgage Basics Everyone Should Know
People are attracted to teaser rates because the monthly payments are much lower (to start) and banks love them because they can be more profitable than a regular mortgage. Buying a home is so expensive and the lower monthly payments are designed to give homeowners some wiggle room in their finances shortly after buying.
The concept isn’t new and is similar to credit cards that offer 0% financing for a small period of time or home equity credit lines that offer a rate below prime for the first 3-6 months. Mortgage teaser rates aren’t as common as they used to be but are still available by some lenders.
A rock-bottom interest rate would catch the eye of anyone looking at buying or renewing their mortgage. Without getting into detailed numbers, a low interest rate looks like it would save money over a regular mortgage.
But is it actually cheaper?
When calculating the potential savings, it’s important to compare the effective interest rate over the term of the mortgage. You’ll want to know if the total interest paid over the mortgage term is lower if you choose a ‘teaser’ rate – and by how much.
For example: the reader is looking at spending $400,000 and has a 20% down payment which means he will need to borrow $320,000. He can choose either a 3 year fixed rate of 2.40% or a 3 year fixed rate of 2% for the first year, then 3.25% for the remaining two years.
If he chooses the regular 3 year fixed rate mortgage he would pay about $22,000 in interest (over the 3 year term). If he chooses the 3 year mortgage with a teaser rate, he’d pay $25,786 in interest.
The regular 3 year fixed rate mortgage would save him about $3,700 in interest. This means he would actually be worse off if they chose the teaser rate mortgage.
Along with an increasing rate, teaser rate mortgages can also come with much more fine print. Prepayment options may be more limited than a regular mortgage, and penalties for breaking the mortgage could be higher than expected.
Related: How to Reduce Your Mortgage Penalty
What Can You Really Afford?
When buying a home I think it’s important to be realistic about what you can afford and make sure you’ll have room each month for investing and saving after the mortgage payments are made.
When we bought our house it was below what the bank would offer us. Sure, we could have bought a bigger home in a better location but I didn’t feel comfortable buying ‘too much’ house.
Buying a house is likely the biggest purchase you’ll ever make, so it’s important to make sure you can actually afford it.
If we bought a more expensive home there would be less money for things I enjoy doing – travelling, sports and recreation. I could get by without all these things but I would be less happy, which would likely defeat the purpose of buying a bigger home.
Making a Realistic Budget
When looking at what you can afford I would suggest taking the amount the bank will lend you and then working down from there. You’ll want to make a simple, 5 minute monthly budget that shows where your money is going to come from and what it will be spent on.
Be realistic about your spending habits; if you like to spend $200 per month on clothing now, that likely won’t change when you buy your home – and your budget should reflect this.
Make a budget listing every single monthly expense (including the mortgage) and leave room for some emergency savings – this is money that should be kept in a separate account (ideally taken monthly via automatic payment) and is used in case of an emergency – unexpected job loss, medical bills or vehicle repairs.
Conclusion: mortgage teaser rate might look enticing but in this case it would cost more money than a regular, 3 year fixed rate mortgage. When considering which mortgage is right for you it’s a good idea to make sure you understand the fine print that comes along with it (a mortgage broker should be able to explain all the details), and it turns out a rock-bottom teaser rate isn’t always the cheapest option.