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What is a Two-Step Mortgage?

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A mortgage in which the borrower receives a below-market interest rate for a specified number of years (most often seven or 10), and then receives a new interest rate adjusted (within certain limits) to market conditions at that time. The lender sometimes has the option to call the loan due with 30 days notice at the end of seven or 10 years.

When buying a home, some people consider using a two-step mortgage, which applies two different interest rates at two different times. Initially, this type of mortgage has the same interest rate for a period of time, most commonly five or seven years. When the initial time period is over, the interest rate is adjusted, usually upward, for the remainder of the term of the mortgage - hence the reference to two steps. Two-step mortgages typically have a cap on how much the interest rate can go up at the end of the initial period, but be forewarned that the jump might be more than 5 percent. When should you consider this type of mortgage to finance your home purchase? Well, there are a few situations where this type of mortgage can work to your advantage. One is when mortgage interest rates are high, because there's no point in locking into a high rate for the life of your loan. Another situation is if you know that you will be selling your home before the end of the initial time period when your interest rate remains fixed. That way, you get the benefit of the initial lower rate, but don't have to be concerned about a jump in interest rates when the initial time period is up. Finally, if you can't get a conventional fixed rate mortgage because you don't meet the income requirements imposed by lenders, or you know with some certainty that your income will go up in the next five years, but you can only afford to make smaller mortgage payments at this time, a two-step mortgage may be the right choice for you.