A two-step mortgage is one that has one interest rate for the first part of the mortgage term and a second rate for the other part of the mortgage term. The length of the first interest rate is usually five to seven years. The second interest rate generally carries through the remainder of the length of the mortgage. Usually, the interest rate is below the market interest rate for the initial period and more than the market rate for the second period.
A two-step mortgage may be an attractive option for some people for a number of reasons and under the right conditions. However, in many cases, borrowers prefer the stability of a fixed-rate mortgage, which will lock a borrower in at a guaranteed interest rate for the life of the loan. The conditions that make a two-step mortgage appealing are as follows:
- When interest rates are high at the beginning of the loan but are expected to drop.
- When there is a strong likelihood a borrower will not be in the home longer than five to seven years.
- When the borrower cannot afford higher payments initially, but has a reasonable assurance of being able to afford such payments in the future.
In many cases, a two-step mortgage interest rate will increase at the end of the initial mortgage period. However, after that one adjustment, the mortgage is locked in for the rest of the term. Often, this second rate will be higher than what is available for a fixed rate mortgage and cause a substantial increase in the monthly payments.
If it turns out that the rate is substantially higher than the initial rate, which is almost always the case, a borrower may choose to opt out of a two-step mortgage by refinancing the remaining amount owed. Typically, if a two-step mortgage is kept its full term, the amount ended up paying to the loan company far outweighs the savings that were obtained at the beginning of the loan. That is why refinancing after the initial period is so popular. It is important to maintain a good payment history during this initial phase so that a borrower’s chances of refinancing are not diminished.
Taking out a two-step mortgage can be a risky proposition. However, if done correctly, it can also represent a savings to the borrower. However, it is important to understand that refinancing or selling will likely be required five to seven years in the future.