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 after a specified period of time. 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.
- A convertible ARM is a mortgage with an adjustable rate that can be changed into a fixed rate after some initial period.
- The benefit of a convertible ARM is realized if interest rates are falling. If interest rates are increasing, then the benefit of a convertible arm is lost.
- A convertible ARM usually begins with a teaser rate that is lower than standard rates but then increases after a certain period of time according to an index plus a margin.
- After the conversion to a fixed rate, the new rate will almost certainly be higher than what the homeowner was paying under the teaser rate.
How Do Convertible ARMs Work?
When applying for a mortgage, there are a variety of types to choose from, usually with how the interest rate is determined over the life of the mortgage. Convertible ARMs are a hybrid of two mortgage types: a conventional fixed-rate 30-year mortgage and an adjustable-rate mortgage. Fixed-rate mortgages give the borrower the security of knowing that their monthly payment will never change, even if rates rise, which is a conservative and safe approach. 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 London Interbank Offered Rate (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 loan—that is, at a teaser rate below the market average. But within a specified period, often after the first year but before the fifth year, 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 they might have obtained initially.
History of Convertible ARMs
Introduced in the early 1980s, convertible ARMs entered the scene during a period of double-digit fixed-rate mortgages. Because interest rates seemed unlikely, historically speaking, 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 the later 1980s, mortgage government-sponsored enterprises (GSEs) 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.
Downsides to Convertible ARMs
The main downside to a convertible ARM is that it forces the borrower to monitor interest rates and predict future changes, something that even experts can’t do reliably. Also, interest rates on convertible ARMs—both the introductory rate and the fixed rate later—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, then 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.
What is a loan conversion fee?
A conversion clause is a provision within an adjustable-rate mortgage (ARM) loan that allows a borrower to switch from an ARM to a fixed-rate mortgage. In return for this option, though, the lender charges a fee if and when you make the conversion. Although conversion fees typically run to a few hundred dollars—far less than the closing costs incurred if you were to refinance the mortgage—they do add to the overall cost of your loan.
Can you change from an adjustable-rate mortgage to fixed-rate?
Changing from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage can be done in a couple of ways.
- If your mortgage is a convertible ARM, it contains a provision allowing you to switch. Generally, you have to exercise this option early in the loan term—typically within the first five years. You will probably incur a fee for doing so.
- The other way to change is to refinance the mortgage—which means, basically, that you take out a new mortgage (this time with a fixed interest rate) and use it to pay off the current (adjustable-rate) one. In fact, switching from an ARM to a fixed-rate mortgage is one of the most common reasons why people opt to refinance.