Conversion Option

AAA

DEFINITION of 'Conversion Option'

A clause associated with some adjustable-rate mortgages that allows the borrower to convert the variable interest rate to a fixed rate within a certain time period, or at certain future dates. The conversion option is not free; an adjustable-rate mortgage with a conversion option will typically have a higher margin, and therefore higher fully indexed interest rate, or higher costs than an adjustable-rate mortgage without a conversion option.

INVESTOPEDIA EXPLAINS 'Conversion Option'

To analyze the economics of a conversion option, borrowers should total up the cost of the conversion option (an initial higher interest rate and/or higher loan costs) plus the cost of the actual conversion to a fixed rate, then compare this total to the costs of refinancing into a fixed interest rate at a future date.

Remember that a fee must often be paid to convert to the fixed rate, and the fixed rate that the ARM is converted to is typically based upon the market rate at the time of conversion plus a certain percentage. If the future refinancing costs are estimated to be less than the total costs of the conversion option, then the conversion option is not economical. The borrower would be better off with a traditional ARM with the intent to refinance into a fixed interest rate at a future date.

RELATED TERMS
  1. Droplock Security

    A security that is issued with a variable or floating interest ...
  2. Capped Rate

    An interest rate that is allowed to fluctuate, but which cannot ...
  3. Adjustable-Rate Mortgage - ARM

    A type of mortgage in which the interest rate paid on the outstanding ...
  4. Fixed Interest Rate

    An interest rate on a liability, such as a loan or mortgage, ...
  5. Variable Interest Rate

    An interest rate on a loan or security that fluctuates over time, ...
  6. ARM Margin

    A fixed percentage rate that is added to an index value to determine ...
Related Articles
  1. 4 Steps To Attaining A Mortgage
    Credit & Loans

    4 Steps To Attaining A Mortgage

  2. How Mortgage Refinancing Affects Your ...
    Credit & Loans

    How Mortgage Refinancing Affects Your ...

  3. How Interest Rates Affect The Housing ...
    Economics

    How Interest Rates Affect The Housing ...

  4. Understanding Your Mortgage
    Personal Finance

    Understanding Your Mortgage

comments powered by Disqus
Hot Definitions
  1. Due Diligence - DD

    1. An investigation or audit of a potential investment. Due diligence serves to confirm all material facts in regards to ...
  2. Certificate Of Deposit - CD

    A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate ...
  3. Days Sales Of Inventory - DSI

    A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory ...
  4. Accounts Payable - AP

    An accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable ...
  5. Ratio Analysis

    Quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items ...
  6. Days Payable Outstanding - DPO

    A company's average payable period. Calculated as: ending accounts payable / (cost of sales/number of days).
Trading Center