What it means
Lenders often offer a lower rate at the start of a loan to attract borrowers. This starting rate is called the initial interest rate, and it may be fixed for a few months, a year or several years.
It is sometimes called a teaser rate when it is set noticeably below the level the loan will later reach. When the initial period ends, the loan moves to what is known as the fully indexed rate.
That rate is built from a published market benchmark, called the index, plus a fixed percentage set by the lender, called the margin. Because the index moves with the market, the new rate can be higher or lower than the starting rate.
The practical effect for the borrower is a change in the repayment. A low initial rate gives a lower monthly payment at first, but a reset to a higher rate can lift the payment sharply, a risk often called payment shock.
Many loans limit how far the rate can rise at the first reset and over the life of the loan. For businesses the same idea applies to commercial mortgages, credit lines and equipment finance.
A finance team should model the cost at the reset rate, not just the starting rate, and test what happens if the index rises. The key nuance is that the initial rate describes only the first stretch of the loan.
Judging a loan on this rate alone is like judging a restaurant by its introductory discount. Lenders price the initial period using their own funding costs and their view of how many borrowers will stay after the reset.
Some borrowers refinance before the reset to avoid the higher rate, but refinancing carries fees and depends on the borrower qualifying again. Counting on a refinance is therefore a risk in itself, not a plan.
In practice
Real-world examples.
Example
A homeowner takes an adjustable mortgage with a low initial rate fixed for five years. He budgets using the reset rate from the first day, so the later increase does not catch him out.
Example
A small manufacturer arranges a credit line whose initial rate is fixed for twelve months. Its treasurer asks the bank for the index and margin in writing so she can forecast interest cost beyond the first year.
Example
A property investor compares two commercial loans. One has a low initial rate with a large margin, and the other has a higher rate that is fixed for longer, and the investor chooses the second because the total cost over the holding period is lower. He keeps a spreadsheet showing the total interest cost at three different index levels, so the comparison is not based on a single guess.
Formula
Calculation
Monthly interest = Loan balance x Annual rate / 12
Fully indexed rate = Index + Margin
Consider a $300,000 loan with an initial rate of 3.6%, ignoring principal repaid to keep the comparison simple. Monthly interest at the initial rate is 300,000 x 0.036 / 12 = 10,800 / 12 = $900.
At reset the index stands at 4.5% and the lender's margin is 2.5%, so the fully indexed rate is 4.5% + 2.5% = 7.0%. Monthly interest becomes 300,000 x 0.07 / 12 = 21,000 / 12 = $1,750. The monthly interest cost rises by 1,750 - 900 = $850.Case study
Seen in the real world.
Harbourview Cafes is an illustrative, fictional chain that borrowed $600,000 to refit three locations. The bank offered an attractive initial rate of 3.2% for two years, after which the loan would reset to the index plus a 3% margin.
The owner was ready to sign, but the finance manager built a simple model. At the starting rate the annual interest was 600,000 x 0.032 = $19,200, but at a reset rate of 7.5% it would be 600,000 x 0.075 = $45,000.
The gap of $25,800 a year was larger than the profit forecast for one of the three cafes. In this illustrative story, the company negotiated a longer fixed period at a slightly higher rate and avoided the squeeze. The bank's relationship manager said such comparisons were becoming standard, because customers who understood the reset rate were far less likely to default later.
Watch out
Common mistakes.
- Budgeting for the whole loan at the initial rate, when the rate usually resets after the introductory period.
- Comparing loans on the starting rate alone, without looking at the index, the margin and any rate caps.
- Assuming the rate can only rise at the reset, when it can also fall if the index falls.
Questions
People also ask.
What is the difference between an initial rate and a fixed rate?
An initial rate applies only for the introductory period, while a fixed rate stays the same for the entire term of the loan.
What is a margin?
The margin is the fixed percentage the lender adds to the index to arrive at the fully indexed rate.
Are there limits on how much the rate can change?
Many adjustable loans include caps on the size of each adjustment and on the total increase over the life of the loan, and the loan agreement states them.
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