Two-Step Mortgage

What is 'Two-Step Mortgage'

A two-step mortgage offers a beginning interest rate for an agreed-upon introductory period. The period usually lasts for five to seven years. Often a two-step loan 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.

BREAKING DOWN 'Two-Step Mortgage'

A two-step mortgage is an attractive option for borrowers in certain situations. Borrowers who want to enjoy a lower-than-market interest rate and lower monthly payment over the first several years of the loan are are the classic consumers for a two-step loan. Other familiar two-step borrowers are homeowners who expect to sell the home before the initial period expires. Also, those buyers who believe that interest rates will fall during the loan’s initial rate period would make 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. Not refinancing is rare since the two-step borrower is very likely to refinance or sell the property to avoid the interest rate hike.

Two-Step Loan vs. Adjustable-Rate Mortgages

Two-step mortgages are often referred to as Often confused as adjustable-rate mortgages (ARMs) two-step and ARMs do not have interchangeable terms. Two-step loans feature one re-adjustment 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 first rate adjustment is at five years, then once every five years following. Other examples include a 7/1 ARM which adjusts at the 7-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 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.