DEFINITION of 'Two-Step Mortgage'

A mortgage that offers an initial fixed-interest rate for a period of time (usually 5 or 7 years) after which, at a predetermined date, the interest rate adjusts according to current market rates. At the adjustment date, the borrower might have the option of choosing between a fixed-interest rate (based on current market rates) for the remaining term of the mortgage, or a variable interest rate structure for the remaining term of the mortgage.

BREAKING DOWN 'Two-Step Mortgage'

Borrowers who choose a two-step mortgage carry the risk that the interest rate on the mortgage will adjust upward after the fixed-interest rate period expires. This risk should be understood and measured. The interest rate cap structure of the mortgage, including the index to which the mortgage is tied and the margin, should be known and analyzed. Many two-step mortgage borrowers plan on refinancing or moving before the initial fixed-interest rate period ends, this itself is a risk known as refinancing risk.

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