Two-Step Mortgage

As a borrower plans to purchase a home, they have many choices for financing. Which type of mortgage he or she chooses depends on financial needs and their overall financial picture.

Some choose the stability of fixed-rate loans, or take a risk with adjustable-rate mortgages (ARMs) in order to get a lower initial interest rate and monthly payment.

For those who want the stable interest rates of a fixed mortgage with the lower initial interest rate of the ARM, there is a "third way". This "third way" is the hybrid mortgage, which combines aspects of both. Hybrids come in many varieties, one of which is the two-step mortgage.

The Two-Step Mortgage article discusses what the two-step loan is, how it works, and its pros and cons, so that borrowers can determine if this type of loan serves their needs

A two-step mortgage is appropriate for buyers who meet the following conditions:

• Interest rates are high and the borrower does not want to be locked into a high rate for the life of the loan, and/or
• Borrower can only make smaller payments initially, and/or
• Borrower plans to move or refinance in five to seven years

With this type of mortgage, the borrower's monthly payments during the early years could be considerably lower than they would be with a fixed loan, as the comparison table in this article shows.

The home-buying process is full of decisions, and one of the first ones the borrower makes concerns financing. What kind of mortgage will suit the financial needs and goals of the borrowing party?

The borrower may wish to consider an Adjustable-Rate Mortgage if the borrower:

• Is planning to stay in the home for at least five to ten years or more
• Desires stable monthly payments that never change...
• Wants to take advantage of low initial interest rates and low initial monthly payments
• Does not think they are going to be in the home a long time
• Is comfortable with monthly payments that could change (and possibly go up)

However, if the borrower is not comfortable with an ARM because of concerns about the risk of having a mortgage whose interest rate can rise over time, there is a "third way." This "third way" is known as the "hybrid" or combined mortgage, which combines the stable interest rates of a fixed mortgage with the lower initial monthly payments of an ARM.

There are different types of hybrid mortgages to meet different people's needs. The borrower may feel a hybrid loan is a better choice if:

• Interest rates are high and the borrower does not want to lock into a high rate for the life of the loan, and/or
• The borrower does not currently have the income to qualify for a fixed-rate mortgage, and can only afford to make smaller payments initially, but knows with some degree of certainty that their income will go up in the next five to seven years, and/or
• The borrower plans to move or refinance in five to seven years...

This article focuses on the two-step mortgage, and enables a borrower to decide if a two-step meets their financial needs and goals, by answering the following questions about it:

• What is it?
• How does it work?
• What are the pros and cons?

What is It?

As noted above, the two-step is in the "hybrid" mortgage family. As a hybrid, the two-step mortgage combines aspects of fixed-rate and adjustable-rate mortgages (ARMs).

A two-step mortgage is a fixed-rate loan whose interest rate with one adjustment, after either five or seven years.

How does it work?

Two-step mortgages start off with a rate that is usually lower than the prevailing market rate for a fixed-rate loan. After a designated period, the interest rate changes to a current market rate and remains the same for the life of the loan.

The two most common two-step mortgages are:

• The 5/25 two-step mortgage. This loan offers an initial five-year fixed rate. After the initial period, there is one rate adjustment, and the adjusted rate stays the same for the remaining 25 years of the loan.
• The 7/23 two-step mortgage. This loan offers an initial seven-year fixed rate. After the initial period, there is one rate adjustment, and the adjusted rate stays the same for the remaining 23 years of the loan.

Some say that two-step loans have advantages that provide "the best of both worlds", for example, the best aspects of both fixed-rate mortgages and ARMs. With a two-step loan, the borrower:

• Qualifies with a low starting interest rate
• Can pay as little as possible initially, but still has protection against interest rate changes
• Gets stable, predictable payments for the first five or seven years and then, after the adjustment, for the remaining 25 or 23 years of the loan
• Is protected from rising interest rates during the early years of home ownership
• Has time to increase earnings or assets (or sell or refinance) before the rate adjustment at the end of five or seven years

As with ARMs, the main disadvantage of this loan type is that the monthly payment is likely to be higher after the adjustment. Here again however, if the borrower intends to sell or refinance the home once the initial period or first adjustment ends, or if they have sufficient income to meet the potentially higher payments, then this may not be a challenge.

Payment comparison

The following example compares what the borrower would pay on a $250,000 mortgage with a 5/25 two-step that starts at 4% and moves up to 6%, versus a 30-year fixed-rate at 6%.

The two-step can save money every month as compared to a 30-year fixed during the initial period of the loan (in this example, savings are about $305 per month).

If the borrower keeps the two-step loan after the year five adjustments, the payment is likely to rise because interest rates rise to the prevailing market rate for the remainder of the loan. Additionally, the payments after the initial period \ amortize for 23 or 25 years (depending on whether the loan is a 7/23 or 5/25 loan), which also can increase the remaining payments because they are compressed into a shorter period. Again, as long as the borrower is comfortable, or plans to sell or refinance before the initial period ends, then this does not have to be an issue.

What are the pros and cons?

As we have seen, a two-step is an appropriate choice if the borrower wants "the best of both worlds", or the low initial interest rates of an ARM combined with the interest rate stability of a fixed mortgage.