Many adjustable rate loans offer a start rate. This is a very low rate that lasts for only a short time (usually three to six months) before your actual interest rate begins.
Start rates are not only confusing and misleading, but they also are, in many instances, scams. A lender offering a start rate as low as 2% cannot get the money to lend to you at that rate. This means that the lender is taking a loss for the first few months of your loan. Lenders are not in business to lose money.
A start rate is similar to a retail store offering a specific item at a cost so low that they lose money selling it. This is called a loss leader. The idea is that when you come to the store to buy the item, you will buy other items that are profitable. The difference between the loss leader and the start rate is that you can buy only the loss leader item and leave the store. You cannot get the start rate only. You have to take the profitable part of the loan, as well.
There are several advantages of a low start rate for the lender, especially the less-than-honest lender. First, it is a wonderful advertising gimmick. The naïve borrower hears only the words 2% mortgage loan. This is exactly the type of borrower that this lender wants, someone who can be sold a very profitable loan.
Another advantage is that the lender can qualify the borrower at the start rate. This is good for getting the loan, but puts many borrowers in over their heads when the true payments have to be made. To prevent this, lenders often connect the payment increase to the start-rate payment. When the interest rate jumps to the real rate, the payment does not increase to cover it, also putting the borrower in a poorer financial position.
While the start rate may seem to be beneficial for you, lenders actually use it to their own advantage.
Example: Your start rate is 2%, requiring a payment of $2,000 per month. After a few months, the rate becomes 2% over the one-year Treasury Bill index, for a total interest rate of 6%.
The adjustment on the payment is a maximum of 7.5%. On a $300,000 loan, an interest rate increase of 4% is $12,000 per year, or $1,000 per month. The payment increases by 7.5% to $1,300 per month, a shortfall of $700 per month.
Since the borrower is not paying enough interest to reduce the principal balance, the interest owed but not paid is added to the principal. This creates negative amortization. Now the borrower is no longer reducing the term of the loan. Since the principal balance is increasing, the borrower is now paying compound interest.
At some point in time, the loan must be repaid. This can be done by an increase in the monthly payments necessary to amortize the loan, creating an extreme burden on the borrower, or by a balloon payment that would necessitate refinancing. This may not be possible, since much more money is owed than was originally borrowed. Even if it all works out because the borrower is becoming financially stronger and home prices are increasing, there was a major risk and major expense over a more sensible loan.
There can be a good use of a start rate to qualify a buyer if the start rate is closer to the real rate and the payment adjustment enables the borrower to at least pay the interest once the loan adjusts to the permanent rate formula. Then the payment can gradually adjust to an amount that pays on the principal.