Banks have been using a “teaser,” or an artificially low, introductory interest rate on mortgage loans and credit card for years. While various banks have flirted with them for commercial loans over the last ten years, it is now becoming more common place. Banks use teaser rates to as a customer acquisition tactic, as the structure strongly appeals to two strong human drives: deferral of costs, and immediate gratification. Teaser rates are so effective because customers obtain the service immediately, but pay for it in the future, a move that has a lower emotionally perceived cost.
A number of lenders are currently offering teaser rates on commercial loans (Regions, Bank of America, Rabo Bank, BB&T are just some). Because the teaser rate is only temporary, the bank may actually earn a higher return on the loan with a teaser rate than without it, if the loan is properly structured so that the interest rate in the later years more than offsets the teaser rate. We set out to quantify if teaser rates can be an effective marketing tool and a profitable structure for community banks. The answer is yes, with some caveats.
We built a model (available free to financial institutions HERE in our Resource Center) that tests any loan and allows the user to input the loan size, amortization period, term, rate, cost of funds, origination costs and maintenance costs. The model also allows the user to input any teaser rate and period of the teaser rate. The model mathematically and graphically outputs the average life of the loan and the lifetime value of that loan. We believe that the correct measure to use when assessing the non-risk adjusted value of the loan is the lifetime value. The lifetime value is the net present value of all future expected income, minus cost of funds, origination costs and maintenance costs. We exclude the reserves and other capital charges because we are comparing the same loan, same credit risk and same per period credit costs with and without a teaser period.
We assumed that teaser rates would not be profitable for community banks for the average commercial credit. The reasoning is that community bank credits have short contractual life and even shorter expected life. Furthermore, we also assumed that because of the average size of a community bank loan, a teaser rate would make the loan much less profitable.
We built various loans, using different dollar amounts and terms. We subjected the loans to a teaser rate ranging from one to twelve months. We used teaser rates from 0% to 2%. Results show that teaser rates destroy the lifetime value of a loan if the loan is less than $500,000 and shorter than five years to maturity. However, on larger loans (over $1 million) and longer terms (seven years or longer), teaser rates may actually add lifetime value.
As an example, on a $250k commercial credit, 25-year amortization and five-year term, with a rate of 4.00%, the lifetime value is a little over $20k. With a teaser rate of 0% for twelve months, the loan’s lifetime value does not approach $20k until the fixed rate for the last four years is greater than 5.00% (an unrealistically high rate even with a teaser structure). An early prepayment of the loan makes the teaser rate even more damaging to lifetime value.
On the other hand, with a larger credit of $1 million, and a 25-year amortization and 10-year term, with a rate of 4.50%, the lifetime value is $207k. With a teaser rate of 0% for 12 months, the loan’s lifetime value approaches $207k with just a 50 basis points increase in the loan rate (from 4.50% to 5.00%). Prepayment protection on longer loans makes the lifetime value even more impressive, even with the teaser rate.
Our model is available to any banker that would like to take a look at the methodology and see if they want to incorporate the tactic to help drive loan volume.
The conclusion to this analysis is that loan size and average loan life drives lifetime value and can compensate for an initial teaser loan rate. Larger loans are more profitable because of the proportional lower origination and maintenance costs. Thus, a larger loan can make up the teaser rate shortfall faster. Also, longer maturity credits are more profitable because they offer the lender a longer stream of revenue relative to the risk which offsets initial costs and the teaser rate. Prepayment protection on longer loans is another powerful way to increase lifetime value of loans (our prepayment valuation analysis can be found HERE).
We conclude that community banks can also take advantage of teaser rates, if they properly structure these loans. In today’s competitive lending environment and low current interest rates (but with interest rates expected to rise in the near future), selectively offering teaser rates may be an effective marketing tool and a potent way to play on the borrower psychology.
To get the Teaser Rate Commercial Loan Structuring Model, go HERE.
Submitted by Chris Nichols on May 27, 2015