2-Step Mortgage

What Is a Two-Step Mortgage?

A two-step mortgage offers a beginning interest rate for an agreed-upon introductory period. This period usually lasts for five to seven years. A two-step loan often helps a borrower during the construction of a property. After completion of the structure and when the initial period ends, the interest rate adjusts to reflect prevailing interest rates.

Key Takeaways

  • A two-step mortgage is a mortgage that has both an introductory rate for a lender, and then a higher rate beyond the initial borrowing period.
  • Two-step mortgages appeal to buyers who are constructing their own homes, or who plan to flip the home or property before the loan period expires.
  • A two-step mortgage might also be undertaken by a buyer who expects that interest rates will probably drop during the initial rate period and therefore doesn't want to be locked into one rate for the duration of the loan.
  • Lenders may offer two-step mortgages as a way to bring in a broader pool of buyers, many of whom would otherwise not qualify for a traditional loan.
  • Two-step loans are different from adjustable-rate mortgages (ARMs), as they only readjust a loan's interest rate once, whereas some ARMs will readjust multiple times over the life of the loan.

Understanding a Two-Step Mortgage

A two-step mortgage is an attractive option for borrowers in certain situations. The classic consumers for a two-step loan are borrowers who want to enjoy a lower-than-market interest rate and lower monthly payment over the first several years of the loan. Other familiar two-step borrowers are homeowners who expect to sell the home before the initial period expires. Also, buyers who believe that interest rates will fall during the loan's initial rate period are likely candidates for a two-step loan.

Lenders are attracted to two-step mortgages because they bring in borrowers who might not otherwise qualify for a traditional loan. These borrowers absorb the market risk represented by rising interest rates.

Typically, the interest rate at the end of the initial period will be higher than the initial rate. When interest rates are higher at the end of the beginning period, it makes the loan a more profitable deal for the lender. Also, when the borrower chooses not to refinance over the course of the loan, and the rate resets to a higher interest, the lender will receive higher repayments from the loan. However, not refinancing is rare since the two-step borrower is very likely to refinance or sell the property to avoid the interest rate hike.

Between 5 and 7 Years

The typical introductory period for a two-step mortgage.

Two-Step Loan vs. Adjustable-Rate Mortgages

Two-step mortgages are often confused with adjustable-rate mortgages (ARMs). Two-step loans feature one readjustment of a loan's interest rate at the end of the initial rate period. At this point, the interest rate is locked in for the life of the loan, often 25 years. ARMs, however, come in many varieties and will often readjust the borrower's interest rate many times over the remainder of the loan.

ARMs are typically referred to by a pair of numbers describing their terms, such as a 5/5 ARM. In this case, the initial rate adjustment occurs at five years, then once every five years following. Other examples include a 7/1 ARM, which adjusts at the seven-year mark, then each year following, and a 2/28 ARM which adjusts after two years, then remains at that rate for the remainder of the 30-year loan. These ARMs are two-step mortgages, but there are many other rate adjustment arrangements.

The Two-Step Construction Loan

Another type of two-step loan is designed to help buyers finance an initial stage of construction, followed by a more traditional loan. A separate construction phase is necessary because the collateral used for a traditional loan, the home itself, does not yet exist. 

This loan is generally interest-only for the initial period, with a higher interest rate but a much shorter life than a standard loan. The lender typically approves both the homebuyer and the contractor and releases payments to the contractor on an as-needed basis. Once construction is complete, the loan can be rolled into a typical mortgage or paid off before setting up a mortgage for the completed project.