Two Step Mortgage

Two-step mortgage definition


A two step mortgage is typically structured to provide lower interest rates and lower monthly payments during the first five to ten years of its existence; after that, the interest rate typically rises significantly and monthly payments follow suit. The two-step mortgage arrangement is ideal for young professionals just beginning their careers, since it allows them to purchase a home at their current income level that might otherwise be beyond their financial means. Initial interest rates for these mortgages are often set below the current market rate; mortgage lenders compensate for this shortfall by setting the interest rate relatively high during the longer second period of the mortgage agreement.

Two-step mortgage advantages


The advantages to the individual borrower are obvious; the lower initial interest rate allows the purchase of a much more expensive home with affordable monthly mortgage payments. Because personal income typically increases over the lifetime of an individual, in most cases the higher payments will begin at a time when the borrower is earning more money and is better financially able to manage the increase. For lending institutions, the implementation of the initial teaser rate allows them to attract a larger number of customers and make more loans, thus improving their overall profitability. Additionally, at the end of the initial period of low interest, some homeowners will continue the mortgage payments at the higher interest rate; this occurs most often when higher interest rates are prevalent at the time that the initial interest rate ends.

Drawbacks of two-step mortgage arrangements


For borrowers, two step mortgages can create a false sense of financial security that may prove unfounded; the shock of significantly higher payments after the initial teaser interest rate is over can sometimes force financially unprepared individuals into foreclosure. This is especially true for individuals who may have experienced financial difficulties, unemployment, or credit problems during the initial years of the two step mortgage; even if lower interest rates are available, the borrower or borrowers may not qualify for a refinance and may end up in serious financial difficulty when the higher payments begin. For this reason, it’s essential for two-step mortgage borrowers to monitor their finances carefully and to plan for refinancing or absorbing the additional cost of mortgage payments once the initial low teaser interest rate of the two step mortgage is bumped up to the higher rate.

Two step mortgages can provide a solid entry point for young professionals into the real estate market. Savvy investors can benefit from the below-average interest rates available on these mortgages, especially if they refinance as soon as the initial interest rate period ends; this makes two step mortgages a solid choice for most real estate speculators. First-time homeowners and those financially less responsible, however, may find themselves in trouble when the initial low interest rate ends and their monthly mortgage payments increase. As a result, it’s advisable for borrowers to make plans in advance to refinance the loan or budget extra funds to cover the additional monthly payment amount before the initial interest rate expires.
Tim Ord
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