What is a Convertible ARM
A convertible ARM is an adjustable rate mortgage (ARM) that gives the borrower the option to convert to a fixed-rate mortgage. Convertible ARMs are marketed as a way to take advantage of falling interest rates and usually include specific conditions. The financial institution generally charges a fee to switch the ARM to a fixed-rate mortgage.
BREAKING DOWN Convertible ARM
Convertible ARMS are a hybrid of two mortgage types: the conventional fixed-rate 30-year mortgage, and the adjustable-rate mortgage (ARM). Fixed-rate mortgages give the borrower the security of knowing his monthly payment will never change, even if rates rise; over time, the payments effectively decline relative to inflation. An adjustable-rate mortgage begins with a much lower introductory “teaser” rate, but after a set period (typically five years) the rate is adjusted according to an index, such as the LIBOR, plus a margin. The rate is generally adjusted every six months and can go up or down (within limits outlined in the contract).
With a convertible ARM, the mortgage begins like a 30-year adjustable-rate—that is, at a teaser rate below market average. But within a specified period, often after the first year but before the fifth, the borrower has the option to convert to a fixed rate. The new interest rate is usually the lowest rate offered within the seven days before locking in. Thus if interest rates are dropping, the borrower can get a lower fixed rate than he might have obtained initially.
Convertible ARMs Can Make Sense When Rates Are High
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 great likelihood of lower rates in the future. Early convertible ARMs were expensive and contained onerous restrictions. But in 1987, the government-sponsored mortgage enterprises Fannie Mae and Freddie Mac began buying convertible ARMs on the secondary market; since most commercial banks sell their mortgage loans on the secondary market, the acceptance of convertible ARMs by the two mortgage giants led to their rapid expansion. Competition, in turn, brought lower fees and less restrictive conditions.
The main downside of convertible ARMS is that they force the borrower to monitor interest rates, and predict future changes—something even experts can’t do reliably. Also, interest rates on convertible ARMS—both the introductory rate and the later fixed rate--are usually a little higher than market rates. And while borrowers do not pay closing costs when converting the mortgage, lenders do charge fees. Meanwhile, if interest rates rise during the introductory period, the benefit of a convertible ARM is lost. Finally, the monthly payment after conversion will almost certainly be higher than what the homeowner was paying under the teaser rate, albeit with the security that it will remain fixed.