2/28 Adjustable-Rate Mortgage (2/28 ARM)

What is '2/28 Adjustable-Rate Mortgage (2/28 ARM)'

A 2/28 adjustable-rate mortgage (2/28 ARM) is a type of 30-year home loan that has an initial two-year fixed interest rate period. After this 2-year period, the rate floats based on an index plus a margin. The initial teaser rate is below average for conventional mortgages, but the adjustable rate can rise significantly. Since banks don’t make much money on the initial teaser rate, 2/28 ARMS include hefty pre-payment penalties during the first two years.

BREAKING DOWN '2/28 Adjustable-Rate Mortgage (2/28 ARM)'

The 2/28 ARM became popular during the real estate boom of the early 2000s when soaring prices put conventional mortgage payments out of reach for many buyers. For example, a $300,000 conventional 30-year mortgage would carry monthly payments of $1610. But a 2/28 ARM with an initial teaser rate of 3-percent would require monthly payments of just $1265.

Potential Pitfalls of 2/28 ARMS

The Catch-22 of the 2/28 adjustable-rate mortgage is that after two years the rate is adjusted every six months, typically upward, by a percentage based on the London Interbank Offered Rate  (LIBOR) plus an additional margin. 2/28 ARMS have safety checks built in, such as a lifetime interest rate cap and limits on how much the rate can increase, or decrease, with each period. But even with caps, homeowners can face jaw-dropping payment spikes.

In the example given above in the $300,000 30-year 3% ARM 2/28 loan, if after two-years the LIBOR is 2.7 and the margin is 1.5, the interest would increase by 4.2 percent, to a total of 7.2 percent. This 7.2% rate could be well above current conventional mortgage rates. The homeowner’s monthly payment would increase overnight by more than 60%, to $2036.

Many homeowners during the boom failed to understand how a seemingly small rate increase could dramatically boost their monthly payment. And even those who were fully aware of the risks viewed 2/28 ARMs as a short-term financing vehicle. The idea was to take advantage of the low teaser rate, then refinance after two years to either a conventional mortgage or, if their credit was not good enough for that, to a new adjustable mortgage. And, given the spiking real estate prices, kick the debt can further down the road. To many, this made a certain amount of sense, since, after all, the borrower’s home equity was rising fast.

Trouble came with the market collapse in 2008. Home values plummeted. Many owners of 2/28 ARMS found themselves unable to refinance, make their payments, or sell their homes for the value of the outstanding loan. The rash of foreclosures led to stricter loan standards. Today banks are more carefully evaluating a borrower’s ability to make adjustable-rate payments.