What’s a Two-Step Mortgage?

Here’s another loan program you might not have heard of before but could be an attractive option for you. It’s referred to by lenders as a “two-step” mortgage. It’s so called because the interest rate on the mortgage changes once at a predetermined point in the future. There’s the initial rate, or the first step, and then the adjustment, which is the second step.

Two Main Two-Step Mortgage Loans

There are two popular two-step mortgage loans. It’s the 5/25 mortgage program and despite it not being widely promoted or otherwise advertised, it’s a program backed by Fannie Mae or Freddie Mac. There’s also a 7/23 loan. When a lender approves and funds a 5/25 or 7/23 loan, it is then eligible for sale in the secondary market, just like most other conventional loan programs. It’s really nothing exotic but does have a place in the mortgage industry.

A 5/25 mortgage is one where the loan is fixed for five years before making a one-time adjustment at the end of the fifth year and adjusts into a new rate for the remaining 25 year term. A 7/23 loan is fixed for seven years. The attraction? The start rate is lower compared to its conforming fixed-rate cousin, the 30-year loan program. Further, borrowers are approved using the lower rate.

This program isn’t to be confused with a 5/1 loan. With a 5/1 loan, the initial rate is also fixed for five years but at the end of that term, it turns into a one-year adjustable. With a 5/1, because it is indeed an ARM, after five years the rate can go higher each year. Most such 5/1 programs have an interest rate cap at 5.0% over the initial rate. With a two-step mortgage however, once the rate makes its initial adjustment, it remains there for the life of the loan. No more changes.

The adjustment is also predetermined when and how. For example, a common 5/25 loan might take the Fannie Mae 60-day net yield (I know, getting into the weeds a bit here) and adds a small margin, say 0.50%. If a 5/25 loan were to adjust and the net yield was 3.50%, the new rate for the remaining 25 years would be 3.50% + 0.50% = 4.00%.

How it Works

With a two-step mortgage, borrowers enjoy start rates just below market rates for 30 year programs and only makes a one-time adjustment, providing less risk to the borrower over the life of the loan. It should still be noted however that the second step adjustment will be a bit higher than prevailing conforming 30 year fixed rate programs. Yet when comparing the 5/25 or 7/23 with a 5/1 or 7/1 loan, the exposure to higher rates is much less with the two-step mortgage option.

Is this a good program for you? That depends upon several factors which we’ll discuss together but it primarily relies on how long you intend to keep the property as well as qualifying at a lower rate. If you’re looking an extended period, say anything such as 10 years or more, it’s probably a good option to stay traditional and move toward a 30 year fixed rate or 15 year fixed rate program. On the other hand, if you’re not sure but aren’t that attracted to a 5/1 or 7/1 choice that can adjust once per year after the initial period, the 5/25 and 7/23 just might be the perfect fit.

What’s Next

Let’s talk over the phone or we can meet at my office and discuss your options. With a brief conversation I can prequalify you and give you a range of qualifying loan amounts as well as consider your plans and financial goals. The two-step mortgage certainly isn’t as common as a traditional 30 year fixed, but it does play an important role. It might very well be your best loan choice.