What Is a Discounted Mortgage and How Does It Work?
Understand what a discounted mortgage is, how this home loan type functions, and how it compares to other financing options.
Mortgages are financial instruments that enable individuals to purchase property by borrowing funds, typically from a bank or other lending institution, with the property itself serving as collateral. These loans come in various forms, each with distinct features impacting repayment and financial planning. Among these options is a type of mortgage known as a discounted mortgage, which functions differently from other common mortgage products.
Understanding a Discounted Mortgage
A discounted mortgage, often referred to in the United States as an Adjustable-Rate Mortgage (ARM) with an introductory or “teaser” rate, offers a reduced interest rate for an initial period. This introductory rate is typically lower than the lender’s standard variable rate (SVR), or the fully indexed rate, for a set amount of time. The “discount” refers to this temporary reduction, making initial monthly payments more affordable. For example, if a lender’s SVR is 5% and they offer a 1% discount, the borrower would pay 4% during the initial period.
The fundamental mechanism involves an interest rate that is set a specific percentage below a benchmark rate. After this introductory phase, the interest rate will adjust periodically based on market conditions. The specific terms of the discount, including its percentage and duration, are determined by the lender.
Key Characteristics
The primary characteristic of a discounted mortgage is its variable nature after the initial fixed-rate period. While borrowers enjoy a lower, stable rate during the introductory phase, this rate is not permanent. Most often, the introductory period can range from two to ten years, with common terms including three, five, or seven years. Once this period concludes, the interest rate typically adjusts based on a benchmark index, such as the Secured Overnight Financing Rate (SOFR), plus a fixed margin set by the lender.
This means that monthly payments can fluctuate significantly after the initial discount period. If the underlying index rate increases, the borrower’s payments will rise, and conversely, they will fall if the index decreases. Most adjustable-rate mortgages include caps that limit how much the interest rate can change at each adjustment period and over the lifetime of the loan, providing some protection against extreme increases.
Distinguishing Features
A discounted mortgage stands apart from other common mortgage types, notably fixed-rate mortgages and pure standard variable rate (SVR) mortgages. A fixed-rate mortgage maintains the same interest rate for the entire loan term, providing predictable and stable monthly payments regardless of market fluctuations. In contrast, a discounted mortgage offers initial payment savings but introduces payment uncertainty once the introductory period ends. This trade-off between initial savings and long-term stability is a key differentiator.
Compared to a pure standard variable rate (SVR) mortgage, which is less common in the US and more prevalent in other regions, a discounted mortgage provides a temporary, defined reduction from the lender’s discretionary rate. While both are variable, the discounted mortgage’s initial lower rate is a structured offer. A pure SVR mortgage typically does not include an upfront discount, meaning its rate can change at the lender’s discretion from the outset without an initial preferential period.