What is a 2/28 adjustable rate mortgage (ARM 2/28)
A variable rate mortgage 2/28 (ARM 2/28) is a type of 30-year mortgage with an initial fixed-rate period of two years. After this period of 2 years, the rate floats according to an index plus a margin. The initial teaser rate is lower than average for conventional mortgages, but the adjustable rate can increase significantly. Since the banks are not making a lot of money from the initial teaser rate, the 2/28 ARMS includes heavy prepayment penalties in the first two years.
BREAKDOWN Variable rate mortgage 2/28 (ARM 2/28)
ARM 2/28 became popular during the housing boom of the early 2000s when soaring prices put conventional mortgage payments out of reach for many buyers. For example, a conventional mortgage of $ 300,000 over 30 years would result in monthly payments of $ 1,610. But an ARM 2/28 with an initial teaser rate of 3% would require monthly payments of only $ 1,265.
Potential pitfalls of 2/28 ARMS
The catch-22 of the variable rate mortgage 2/28 is that after two years the rate is adjusted every six months, usually upwards, by a percentage based on the London interbank rate (LIBOR) plus an additional margin. 2/28 ARMS has built-in security controls, such as a lifetime interest rate cap and limits on increasing or decreasing the rate in each period. But even with ceilings, homeowners can face breathtaking payment spikes.
In the example given above for the ARM 2/28 loan at 3% of $ 300,000 over 30 years, if after two years the LIBOR is 2.7 and the margin of 1.5, the interest would increase by 4.2%, for a total of 7.2%. This 7.2% rate could be much higher than current conventional mortgage rates. The owner’s monthly payment would increase overnight by more than 60% to $ 2,036.
During the boom, many homeowners did not understand how a seemingly small rate increase could significantly increase their monthly payment. And even those who were fully aware of the risks considered ARMS 2/28 as a vehicle for short-term financing. The idea was to take advantage of the low teaser rate, and then refinance after two years either a conventional mortgage or, if their credit was not good enough for that, a new adjustable mortgage. And, given the skyrocketing house prices, kicking debt can go further. For many, this made sense because, after all, the home equity of the borrower was increasing rapidly.
Problems arose with the market collapse in 2008. The value of homes has dropped. Many owners of 2/28 ARMS have been unable to refinance, make payments or sell their homes for the value of the current loan. The eruption of foreclosures has led to tighter lending standards. Today, banks are looking more closely at a borrower’s ability to make variable rate payments.