Here’s how to navigate what can be a complicated route to homeownership.
What is a 2/28 adjustable-rate mortgage?
A 2/28 adjustable-rate mortgage (ARM) is a loan product that combines a short fixed rate period with a much longer adjustable term. The first two years of the mortgage are at a fixed interest rate. After the two-year fixed period, the interest rate regularly adjusts based on the mortgage’s stated index.
Borrowers with challenged credit or unverifiable income often have issues securing approval for conventional mortgage products. These borrowers usually have to turn to the subprime lending market. Subprime loan products are more expensive than their traditional counterparts are.
The 2/28 adjustable-rate mortgage is a popular type of subprime loan product. During the first two years, the loan has a “teaser” interest rate that is well below the market rate. After the two-year introductory period, the rate rises significantly.
Advocates of the 2/28 ARM argue that it gives borrowers a chance to improve their credit so that they can refinance into an affordable fixed-rate mortgage once the teaser period is over.
However, homeowners who cannot secure approval for a traditional mortgage face significant jumps in their payments. Some 2/28 adjustable-rate mortgages incorporate prepayment penalties into their contracts, making it expensive for borrowers to get into a more affordable product.
2/28 Adjustable-rate mortgage example
If you have a 30-year mortgage with a low initial fixed interest rate that periodically adjusts after a period of two years, this is a 2/28 adjustable-rate mortgage.
For example, your initial interest rate may be 3 percent. After the two-year teaser period ends, the interest adjusts according to the mortgage’s stated index. The ARM contract ties the interest rate increase to the six-month Libor or Treasury yield, plus a specified spread.
This spread is the “margin.” If the margin is 1 percent and the six-month Libor is 4 percent, this results in an interest rate of 5 percent. When your loan is for hundreds of thousands of dollars, this 2 percent jump dramatically increases the payment.
Ready to become a homeowner? Check out Bankrate’s mortgage calculator to see how the interest rate affects your payments.