Homebuyers face many choices in types of mortgages, from longer-term fixed-rate loans to shorter-term adjustable-rate loans. A 2/28 adjustable-rate mortgage (2/28 ARM) is one type of adjustable rate mortgage that, while less common than the traditional 30-year fixed mortgage, may cater to specific buyers’ needs.
What Is a 2/28 Adjustable-Rate Mortgage (2/28 ARM)?
A 2/28 adjustable-rate mortgage (2/28 ARM) is a 30-year home loan featuring an initial two-year fixed interest rate period. After this two-year period, the rate floats based on an index rate plus a margin.
The initial teaser rate is typically below the average rate of conventional mortgages, but the adjustable rate can then increase significantly. Since financial institutions do not earn much from the initial teaser rate, 2/28 ARMs often include substantial prepayment penalties during the initial two years.
Key Takeaways
- 2/28 Adjustable-Rate Mortgages (ARMs) offer a fixed rate for two years, after which the interest rate adjusts semiannually for 28 more years.
- When ARMs adjust, interest rates change based on their marginal rates and the indexes to which they’re tied.
- Homeowners generally experience lower mortgage payments during the introductory period, but are subject to interest rate risk once the term progresses.
Understanding 2/28 Adjustable-Rate Mortgages (2/28 ARMs)
2/28 ARMs gained popularity during the real estate boom of the early 2000s, as soaring prices put conventional mortgage payments out of reach for many buyers.
Other ARM structures exist, such as 5/1, 5/5, and 5/6 ARMs, which possess a five-year introductory period followed by periodic adjustments. The 15/15 ARMs adjust once after 15 years and then remain fixed for the remaining loan period.
Less common are 2/28 and 3/27 ARMs. For the former, the fixed interest rate applies only to the initial two years, followed by 28 years of adjustable rates. For the latter, the fixed rate is set for three years, with modifications during the subsequent 27 years.
Example of a 2/28 ARM
Let’s say you’re purchasing a $350,000 home and making a down payment of $50,000, resulting in a $300,000 mortgage with an initial interest rate of 5% and monthly payments of $1,906. These calculations assume $230 per month in property tax and $66 per month in insurance costs.
With a 2/28 ARM, your interest rate of 5% remains fixed for two years. Post that period, the rate may change based on an index rate. For instance, if your interest rate subsequently increases to 5.3%, your total monthly costs would rise to $1,961. Your interest rate would then continue to vary over the loan period in line with broader index changes, making total cost estimation complex.
In comparison, a 30-fixed mortgage on the same principal with a 5% interest rate would see you paying $1,906 per month with a total interest payment of $279,987 if not paid off early.
Risks of 2/28 ARMs
The primary risk with 2/28 ARMs is potential interest rate increases. After the initial two years, the rate adjusts every six months, usually upward, based on an index rate plus margin. While built-in safety features like lifetime interest rate caps and periodic limits exist, clients may face considerable payment hikes in volatile markets.
During the housing boom, many borrowers underestimated the impact of even slight rate increases on their payments. Even those aware often viewed 2/28 ARMs as short-term instruments, taking advantage of teaser rates with the notion of refinancing before adjustable periods began. This method backfired during the 2008 market collapse, leading to foreclosure for many due to challenges in refinancing, making payments, or selling properties above loan values.
Today, lending standards have tightened, requiring a thorough evaluation of a borrower’s ability to make payments under adjustable rates.
2/28 ARM vs. Fixed-Rate Mortgage
Understanding the differences between adjustable-rate mortgages like a 2/28 ARM and fixed-rate mortgages is crucial for long-term financial planning.
Adjustable-rate mortgages contain interest rates capable of changing, making monthly payments and overall interest payments unpredictable. Borrowers need to be prepared for potential payment increases.
Conversely, fixed-rate mortgages feature steady interest rates throughout the loan’s duration, offering predictability in monthly payments and making them equal over time.
Is a 2/28 Adjustable-Rate Mortgage Right for You?
A 2/28 adjustable-rate mortgage might benefit those needing lower initial payments and believing they can handle higher future payments. However, for those able to afford higher initial payments, alternative options like 15-year fixed-rate loans may offer more savings through reduced total interest payments.
What are the Disadvantages of an Adjustable-Rate Mortgage?
While adjustable-rate mortgages can offer lower initial monthly payments, borrowers should be cautious about potential increases. Should the interest rate rise, so will payments and overall borrowing costs.
What is a 5/1 ARM with a 30-year Term?
A 5/1 Adjustable-Rate Mortgage (ARM) fixes the interest rate for five years, adjusting annually thereafter over a 30-year term. These are known as 5/1 hybrid ARMs.
Can You Pay off an ARM Loan Early?
Whether you can pay off an adjustable-rate mortgage early depends on the loan terms. Some ARMs may involve prepayment penalties if paid off ahead of schedule, including selling or refinancing.
Related Terms: fixed interest rate, adjustable-rate mortgage, ARM margin, prepayment penalty, conventional mortgage, 5/1 ARM, Federal funds rate, SOFR, lifetime cap, refinancing
References
- U.S. Department of Housing and Urban Development. “Adjustable Rate Mortgages (ARM)”.
- Center for American Progress. “The 2008 Housing Crisis”.
