Conversion Option

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.

BREAKING DOWN '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. ARM Margin

    A fixed percentage rate that is added to an index value to determine ...
  4. Fixed Interest Rate

    An interest rate on a liability, such as a loan or mortgage, ...
  5. Adjustable-Rate Mortgage - ARM

    A type of mortgage in which the interest rate paid on the outstanding ...
  6. Variable Interest Rate

    An interest rate on a loan or security that fluctuates over time, ...
Related Articles
  1. Credit & Loans

    4 Steps To Attaining A Mortgage

    It starts with knowing your choices as well as your price range. We show you how to get there.
  2. Credit & Loans

    How Mortgage Refinancing Affects Your Net Worth

    Find out how to determine whether refinancing will put you ahead or even more behind.
  3. Economics

    How Interest Rates Affect The Housing Market

    Understand how rate changes can affect home prices, and learn how you can keep up.
  4. Personal Finance

    Understanding Your Mortgage

    We walk through the steps needed to secure the best loan to finance the purchase of your home.
  5. Options & Futures

    Make A Risk-Based Mortgage Decision

    Find out how to choose which mortgage style is right for you.
  6. Home & Auto

    Understanding Pre-Qualification Vs. Pre-Approval

    Contrary to popular belief, being pre-qualified for a mortgage doesn’t mean you’re pre-approved for a home loan.
  7. Home & Auto

    6 Reasons To Avoid Private Mortgage Insurance

    Homebuyers who put less than 20% down will likely be forced to secure private mortgage insurance. Here are six reasons to avoid it.
  8. Home & Auto

    10 Tips for Getting a Fair Price on a Home

    When the housing market booms, it's tougher than ever to get a good price. Make sure the house you choose is worth the price you pay.
  9. Home & Auto

    Steps To Buying A Home

    No matter what type of property you’re eyeing, there are steps you can take to protect your investment.
  10. Home & Auto

    Understanding Private Mortgage Insurance

    Private mortgage insurance, or PMI, protects lenders against loss if a borrower defaults.
RELATED FAQS
  1. Do FHA loans require escrow accounts?

    Federal Housing Administration (FHA) loans require escrow accounts for property taxes, homeowners insurance and mortgage ... Read Full Answer >>
  2. Do FHA loans have prepayment penalties?

    Unlike subprime mortgages issued by some conventional commercial lenders, Federal Housing Administration (FHA) loans do not ... Read Full Answer >>
  3. Can FHA loans be refinanced?

    Federal Housing Administration (FHA) loans can be refinanced in several ways. According to the U.S. Department of Housing ... Read Full Answer >>
  4. Can FHA loans be used for investment property?

    Federal Housing Administration (FHA) loans were created to promote homeownership. These loans have lower down payment requirements ... Read Full Answer >>
  5. Do FHA loans have private mortgage insurance (PMI)?

    he When you make a down payment from 3 to 20% of the value of your home and take out a Federal Housing Administration (FHA) ... Read Full Answer >>
  6. How many FHA loans can I have?

    Generally, the Federal Housing Administration (FHA) does not insure more than one mortgage per borrower. This is to prevent ... Read Full Answer >>
Hot Definitions
  1. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  2. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  3. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  4. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
  5. Godfather Offer

    An irrefutable takeover offer made to a target company by an acquiring company. Typically, the acquisition price's premium ...
Trading Center