ELI5: The 2/28 Adjustable Rate Mortgage (ARM)

Advanced Definition
Last updated: Jul 27, 2023

2-28 ARM Explained

Imagine you're going on a roller coaster ride, and you want to try something different for the first two years ā€“ maybe a slow ride followed by a faster one. A 2-28 ARM (Adjustable-Rate Mortgage) is a bit like that roller coaster. It's a type of home loan that offers you a fixed interest rate for the first two years and then switches to a different rate for the remaining 28 years. Let's break it down into simple terms and use our roller coaster example to understand how it works!

šŸ’” Key Ideas

  • 2-28 ARM: A 2-28 ARM, or Adjustable-Rate Mortgage, is a home loan that offers a fixed interest rate for the first two years, followed by an adjustable rate for the next 28 years.

  • Fixed-Rate Period: During the initial two years, borrowers enjoy stable and lower monthly payments due to the fixed interest rate.

  • Adjustable-Rate Period: After the fixed-rate period, the interest rate changes periodically, which can lead to changes in monthly payments over time.

  • Benefits: The 2-28 ARM can be beneficial for those who want lower initial payments, plan to sell the house within the fixed-rate period, or expect interest rates to decrease in the future.

  • Considerations: Borrowers should carefully evaluate the potential risks and uncertainties associated with the adjustable-rate period before choosing a 2-28 ARM for their home loan.

The Roller Coaster Ride Scenario

Think of getting a home loan as going on a roller coaster ride. You'll experience two different parts:

  1. First Two Years: The ride starts with a gentle and predictable part where the roller coaster moves at a fixed speed. This is like the first two years of a 2-28 ARM.

  2. Remaining 28 Years: After the initial gentle ride, the roller coaster takes a sudden turn and speeds up. Now, it becomes a bit unpredictable, like the remaining 28 years of a 2-28 ARM.

Making Sense of the 2-28 ARM

Okay, let's break it down further:

First Two Years: Fixed Rate

During the first two years of your home loan (the "2" part), you'll enjoy a fixed interest rate. It's like having a predictable ride on the roller coaster, where you know exactly how much you'll pay each month.

Remaining 28 Years: Adjustable Rate

After those initial two years, things change ā€“ just like the roller coaster speeds up. The "28" part of the 2-28 ARM means that for the next 28 years, your interest rate can change periodically. It's like the roller coaster taking unexpected twists and turns.

Why Choose a 2-28 ARM?

You might wonder why anyone would choose a 2-28 ARM for their home loan. Well, there are a few reasons:

  1. Lower Initial Payments: The fixed-rate period offers lower and more affordable payments in the first two years.

  2. Short-Term Plans: If you plan to sell the house within the first two years, the 2-28 ARM can be a good choice because you'll enjoy the lower fixed rate and won't experience the adjustable rate.

  3. Taking Advantage of Low Rates: If you believe that interest rates will drop in the future, the initial fixed-rate period allows you to benefit from the current lower rates before they potentially increase.

Example: Sam's Roller Coaster Home Loan

Let's follow Sam's journey as he takes a roller coaster ride with a 2-28 ARM for his new house.

Starting the Ride

Sam gets a 2-28 ARM to buy his dream house. The loan terms offer a fixed interest rate of 4.5% for the first two years. His monthly mortgage payment during this period is $1,200, which fits perfectly into his budget.

YearInterest Rate (%)Monthly Payment ($)
Year 14.5 (Fixed)$1,200
Year 24.5 (Fixed)$1,200

The Transition

Once the first two years (the fixed-rate period) are over, the roller coaster takes a turn. The loan terms now switch to an adjustable rate for the remaining 28 years. The new interest rate is 5.0%, and this causes his monthly payment to increase.

YearInterest Rate (%)Monthly Payment ($)
Year 14.5 (Fixed)$1,200
Year 24.5 (Fixed)$1,200
Year 35.0 (Adjustable)$1,250
Year 45.0 (Adjustable)$1,250
.........
Year 295.0 (Adjustable)$1,250
Year 30 (End)5.0 (Adjustable)$1,250

Evaluating the Ride

As Sam's roller coaster home loan journey continues, he sees a gradual increase in his monthly payments over the remaining 28 years. While the initial fixed-rate period provided him stability and lower payments, the adjustable-rate period brings some uncertainty due to potential rate fluctuations.

However, Sam believes that interest rates might decrease in the future, and the 2-28 ARM allows him to take advantage of the current lower fixed rate while he plans to sell the house in the next few years. He's prepared for the unpredictable part of the ride and has a financial strategy in place.

Remember, just like every roller coaster ride, a 2-28 ARM has its thrills and turns. It's essential for Sam and anyone considering this loan type to weigh the benefits and potential risks carefully before hopping on this financial roller coaster!

Conclusion

A 2-28 ARM is like a roller coaster ride with a fixed and predictable period for the first two years and an adjustable and potentially unpredictable period for the next 28 years. It can be a suitable option if you want lower initial payments, plan to sell the house within the fixed-rate period, or expect interest rates to drop. However, like any roller coaster ride, it's essential to understand the twists and turns of the loan terms, so you can make an informed decision about your financial journey!