Initial Rate Period

What Is an Initial Rate Period?

An initial rate period on a mortgage or other loan includes an introductory interest rate (sometimes known as a teaser rate) that expires at the end of the period. The initial rate period is only included in those loans that offer an introductory rate, which varies by loan type and can be as short as one month or as long as several years.

Teaser loans are an example of mortgages with initial rate periods that offer very low introductory rates used for promotional purposes to entice new borrowers. Borrowers must be aware of the rates that will apply after the initial rate period expires.

Understanding the Initial Rate Period

The initial rate period is the time an interest rate is lower, usually at the beginning of the loan’s life. Borrowers should be careful when choosing a loan or mortgage with an attractive, low initial rate period. While a loan with a low initial interest rate can seem beneficial, low initial interest rates will reset to higher rates at the expiration of the initial rate period. It is essential to consider the interest rate of the loan over time and to do a careful analysis of loan rates and costs.

Adjusted-rate mortgage loans (ARMs) have initial rate periods. These mortgages have an interest rate applied to the outstanding loan balance which varies throughout the loan's life. Typically, the initial interest rate is fixed for a period of time, after which it resets periodically, often every year or even monthly. The rate resets have the basis of a benchmark or an index. Also, additional fees called ARM margin will apply.

Teaser loans with low initial rate period interest rates can help borrowers save considerable amounts of money on early interest costs. However, borrowers must also be aware of the rates that will apply after a teaser rate expires. They should clearly understand the payment terms and requirements detailed in their loan contract before agreeing to a teaser loan’s terms.

Initial Rate Period and Adjusted Rate Mortgage Loans

Some specific ARM loans, such as 3-2-1 buydown mortgages, have initial rate periods that are lower, after which the interest rate increases incrementally. The 3-2-1 temporary buydown mortgage allows the buyer a lower initial rate period and provides additional cash up-front during the closing process. 

By offering a greater down payment at closing, the buyer can lock in a lower initial rate period and reduce long-term loan costs. The term gets the specific title from the relationship between the initial rate period and the permanent rate. In the first year, the interest will be 3% lower than the permanent rate. In the second year, it will be 2% less, and in the third year 1% lower.

Special Considerations

If you qualify for a mortgage loan at 6% but would like to reduce the mortgage payments for the first few years, you may elect to use a 3-2-1 mortgage buydown. However, the closing costs with this type of loan are higher. With the first year, i.e. the initial rate period, you would pay 3% interest on the borrowed principal. During the second year, the interest rate goes up to 4%. In the final year of the 3-2-1, your interest is 5%. The loan then continues at 6% for the life of the mortgage. 

The key here is to do your research to ensure you don’t pay more money for a lower initial rate period than you end up saving.