2-Step Mortgage Definition

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2-Step Mortgage Definition

What Is a Two-Step Mortgage?

A two-step mortgage provides an introductory interest rate for a certain amount of time. This time frame typically lasts five to seven years. A two-step loan often aids a borrower in building a residence. When the building is finished and the first term expires, the interest rate is adjusted to reflect current interest rates.

Key Takeaways

  • A two-step mortgage is one with a lower interest rate up front for the lender and a higher rate after the first borrowing term.
  • Buyers who are building their own houses or who want to sell the house or other property before the loan term ends are drawn to two-step mortgages.
  • A buyer who anticipates that interest rates will likely decline during the first rate period and does not want to be tied into a rate for the length of the loan may also opt for a two-step mortgage.
  • Two-step mortgages are a tool that lenders may use to attract a larger pool of purchasers, many of whom would not be eligible for a regular loan.
  • Two-step loans vary from adjustable-rate mortgages (ARMs) in that they only allow one interest rate adjustment, while certain ARMs allow many adjustments during the course of the loan.

Understanding a Two-Step Mortgage

In certain circumstances, a two-step mortgage is a desirable choice for borrowers. Borrowers who seek to benefit from a lower-than-market interest rate and lower monthly payment throughout the course of the first few years of the loan are the typical customers for a two-step loan. Homeowners who want to sell their homes before the original term is up are another common kind of two-step borrower. Additionally, purchasers who anticipate a decline in interest rates during the loan’s first rate term are often good candidates for a two-step loan.

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Because they bring in consumers who may not otherwise qualify for a standard loan, two-step mortgages are attractive to lenders. These borrowers take on the market risk that increasing interest rates signify.

The interest rate will typically be greater than the beginning rate at the conclusion of the first term. The loan is a more lucrative transaction for the lender when interest rates are higher at the conclusion of the introductory period. Additionally, the lender will get larger repayments from the loan if the borrower decides not to refinance during the term of the loan and the rate resets to a higher interest rate. The two-step borrower is extremely likely to sell the house or refinance in order to prevent the interest rate increase, therefore not refinancing is uncommon.

Between 5 and 7 Years

The typical introductory period for a two-step mortgage.

Two-Step Loan vs. Adjustable-Rate Mortgages

Adjustable-rate mortgages and two-step mortgages are often mistaken (ARMs).At the conclusion of the first rate term, two-step loans have one interest rate modification. The interest rate has now been fixed for the loan’s whole term, which is typically 25 years. However, ARMs exist in a variety of forms and often change the borrower’s interest rate many times throughout the course of the loan.

ARMs are often identified by a pair of numbers that describe them, such as a 5/5 ARM. In this instance, the first rate adjustment happens after five years, and after that, it happens once every five years. Other examples are a 2/28 ARM, which adjusts after two years, then stays at that rate for the remaining 30 years of the loan, and a 7/1 ARM, which adjusts at the seven-year mark, then every year after. There are other alternative rate adjustment programs, but these ARMs are two-step mortgages.

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The Two-Step Construction Loan

Another kind of two-step loan is made to assist purchasers in financing the first phase of building before they get a more conventional loan. Because the house itself, the security for a conventional loan, has not yet been built, a separate building period is required.

This loan often has a longer term than a typical loan but a higher interest rate for the first time. The lender normally gives its approval to both the homeowner and the contractor, releasing funds to the latter as required. When construction is finished, the loan may either be repaid in full before creating a mortgage for the finished project or rolled into a regular mortgage.

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