A 2 year ARM is a loan with a fixed rate for the first two years that has a rate that changes once each year for the remaining life of the loan. Because the interest rate can change after the first two years, the monthly payment may also change.
A 2 year ARM, also known as a 2/1 ARM, is a hybrid mortgage. A hybrid mortgage combines features from an adjustable rate mortgage (ARM) and a fixed mortgage. It begins with a fixed rate for a specified number of years, but then changes to an ARM with the rate changing every year for the rest of the term of the loan. With a 2 year ARM, the interest rate is fixed for a period of two years, after which it will be adjusted annually.
Basically, an ARM is a mortgage loan that has an interest rate that adjusts, or changes, usually once a year. The benefit of an ARM is that it generally gives you a lower initial interest rate than a fixed rate mortgage. However, an ARM also carries the risk that the interest rate is likely to go up.
A 2 year ARM is tied to an index which in turn determines how much your interest rate will rise or fall at each adjustment period. An index is a published interest rate based on the returns of investments such as U.S. Treasury securities. The rates for these investments change in response to market conditions, so an index tends to track to changes in U.S. or world interest rates.
With a 2/1 ARM, the interest rate does not begin changing based on the index immediately. For example, if you have a 2 year ARM, your interest rate is fixed for the first 2 years of the loan. After 2 years, the interest rate can change annually for the next 28 years until the loan is paid off. The first number in an ARM indicates the number of years of the fixed period while the second number indicates the adjustment interval. An adjustment interval is the period between potential rate changes (in this case, one year).
A hybrid mortgage often offers a lower interest rate than a fixed loan but a higher interest rate than a standard ARM. It gives you the security of knowing what your payments will be for the fixed period of your loan. With a 2/1 ARM, you know exactly what your interest rate will be for the first 2 years. After that, your interest rate, and therefore your monthly payment, could go up or down.
A 2 year ARM could save you money on your monthly mortgage payment, but it does carry with it a significant amount of risk. For example, let’s say you are purchasing a $200,000 house and putting down 20 percent. After borrowing $160,000 at a 7 percent interest rate, your monthly payment on a 30 year fixed rate mortgage would be $1,064.48. A 2/1 ARM could get you into the same house but with a lower initial monthly payment. If you were to get a 2 year ARM with an initial interest rate of 6.25 percent, your monthly payments would be only $985.15 for the first 2 years of the loan. However, after the 2 year fixed period, the interest rate would change based on the index. Because of this, it is essential that you be sure you can still afford the monthly payments if interest rates go up. Most 2/1 ARM’s will have a lifetime payment cap that limits how much the interest rate on your loan can rise.
If you plan to move or refinance prior to the end of the first 2 years of your mortgage, a 2/1 ARM may be right for you. Be sure to run the numbers to make sure it makes sense. You do need to be aware that some states allow prepayment penalties for hybrid arms. If you refinanced your home or sold it during the first 5 years of your loan, you may have to pay the lender a penalty fee. Find out from your lender the consequences, if any, of paying off the loan during the fixed period.
Weigh your options carefully when deciding on the mortgage product that is best for you.