What Is a Two-Step Mortgage and How Does It Work?
Discover how a two-step mortgage works, including its loan structure, interest rate adjustments, and payment changes over time.
Homebuyers seeking flexible mortgage terms may consider a two-step mortgage. This loan offers an initial fixed-rate period followed by a one-time rate adjustment, affecting future payments. It can be a good option for those expecting income changes or planning to sell before the adjustment. However, understanding its structure and risks is essential before committing.
How the Loan Periods Are Structured
A two-step mortgage consists of two phases, each with a different interest rate. The first phase lasts five, seven, or ten years, during which the rate remains fixed, providing stable monthly payments. Borrowers choose this period based on their financial plans or how long they intend to stay in the home.
After this phase, the loan transitions to a fixed rate based on a financial index, such as the U.S. Treasury yield or the Secured Overnight Financing Rate (SOFR), plus a lender-set margin. Unlike traditional adjustable-rate mortgages (ARMs), which reset periodically, this adjustment happens only once.
Lender Qualification Requirements
Lenders consider several factors when approving a two-step mortgage. A credit score of 680 or higher improves the chances of approval and may lead to better terms. Borrowers with lower scores might still qualify but could face higher rates or stricter conditions.
Debt-to-income (DTI) ratio is another key factor. Lenders generally prefer a DTI below 43%, though exceptions exist for borrowers with strong savings or large down payments. Employment history and income stability also play a role, with most lenders requiring at least two years of steady employment. Self-employed applicants may need to provide tax returns and profit-and-loss statements.
Loan-to-value (LTV) ratio is also considered, with most lenders requiring a down payment of 10% to 20%. A lower LTV reduces risk and may eliminate the need for private mortgage insurance (PMI), which adds to monthly costs.
Interest Rate Adjustments
When the fixed-rate phase ends, the loan undergoes a one-time interest rate adjustment. The new rate is based on a financial benchmark plus a margin set at loan origination. Unlike ARMs, which adjust periodically, this rate remains fixed for the rest of the loan term.
If interest rates have risen, borrowers may face higher monthly payments. If rates have fallen, payments could decrease. Some refinance before the adjustment to secure a better rate, though this depends on market conditions and credit standing.
Monthly Payment Calculations
A two-step mortgage results in two distinct payment periods. During the initial fixed-rate phase, payments follow a standard amortization schedule, ensuring predictability.
After the rate adjustment, payments are recalculated based on the new interest rate and remaining loan balance. Since the adjustment happens only once, the new payment remains fixed. If the rate increases, monthly payments rise accordingly. Borrowers should consider that early mortgage payments primarily cover interest, leaving a significant principal balance when the rate resets.
Available Term Options
Two-step mortgages come in structures such as 5/25, 7/23, or 10/20. The first number represents the fixed-rate duration in years, while the second indicates the remaining term after the adjustment.
A shorter fixed period, such as five years, often has a lower initial rate, making it appealing for those planning to sell or refinance before the adjustment. Longer fixed periods, like ten years, provide more stability but may come with a slightly higher starting rate. Borrowers must weigh short-term savings against long-term predictability, as their choice affects both monthly payments and overall interest costs.