What Is an ARM Conversion Option?

An ARM conversion option is a clause associated with some adjustable-rate mortgages (ARM) 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 ARM margin rate (and therefore a higher fully indexed interest rate) or higher costs than ARMs without a conversion option. An adjustable rate mortgage with a conversion option is called a convertible ARM.

Key Takeaways

  • An ARM conversion option is a provision in an adjustable rate mortgage allowing the borrower to convert the variable rate to a fixed interest rate for the remaining term of the loan.
  • Convertible ARMs are marketed as a way to take advantage of falling interest rates and usually include specific conditions and limitations.
  • Lenders generally charge a fee to switch the ARM to a fixed-rate mortgage, as well as a larger ARM margin during the variable period.

How Conversion Options Work

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 sum to the costs of refinancing into a fixed interest rate at a future date.

Introduced in the early 1980s, convertible ARMs entered the scene during a period of double-digit fixed-rate mortgages. The theory was that because interest rates were historically unlikely to go much higher (barring extraordinary inflation), borrowers of convertible ARMs could essentially bet on the greater likelihood of lower rates in the future. Early convertible ARMs were, however, quite expensive and contained onerous restrictions. In today's low interest rate environment, these options are less attractive for many borrowers.

Exercising a Conversion Option Can Mean Higher Fees

Remember: a fee must often be paid to convert to the fixed rate, and the fixed rate to which the ARM is converted 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.

A conversion option, from the context of the insurance industry, can refer to a clause that allows the policyholder to change a term life insurance policy into a whole life policy. Exercising such an option in most cases will incur additional costs for the policyholder. Furthermore, there may be a specific window of time when such a conversion can be requested. A policyholder might choose to convert to guarantee coverage beyond the limits of the term policy they original signed up for.

Under a whole life policy, they might also not have to submit evidence they are in sound health or agree to medical examinations. Having term life insurance with a conversion option clause can be an alternative to paying for a whole life policy from the start, which would include even higher premiums for the policyholder to pay.

A conversion could also be necessary if an individual was covered by group insurance through an employer and, after separating from the company, wants to switch the policy they have been paying for to an individual life insurance policy.

Conversion options can also be found in health insurancefor example, with options for a policyholder to change their critical care coverage from a standard policy to one that specializes in long-term care at private facilities.