Convertible ARM | The bank rate

An adjustable rate convertible mortgage (ARM) is a type of home loan that allows the borrower to change the interest rate structure after a certain period of time. This flexibility is sometimes referred to as a conversion clause or conversion option.

What is an ARM conversion clause?

An ARM conversion clause allows the borrower to convert their ARM loan to a fixed rate loan after a certain period of time, usually for a fee. This option generally comes into effect at any time, from one year after the start of the loan to five years.

With an ARM, the borrower’s interest rate can increase or decrease at predetermined times (for example, every six months or once a year) based on prevailing market rates, which increases or decreases the borrower’s monthly mortgage payment. The rate is based on an index, such as the Secured Overnight Funding Rate (SOFR), and the margin shown in your loan documents.

With a fixed rate mortgage, the rate does not change for the life of the loan, which means the borrower’s monthly payments remain the same. Many borrowers appreciate this stability in their monthly budget. With the alternative, they should be prepared for the possibility of a higher monthly payment.

Many borrowers take out an ARM because the comparable fixed rate is too high for their budget – in other words, the lower introductory rate on the ARM makes it easier to get a lower-cost home. The hope is that their income will rise or rates will drop enough that they can refinance to a fixed rate loan before ARM rates reset. However, this is a calculated risk.

The catch with a convertible ARM: If interest rates go up, including a conversion clause really has no benefit to the borrower. A convertible ARM only works in the borrower’s favor if rates go down – a very difficult outcome to predict.

Conversion clause fees

Mortgage lenders typically charge a fee to be able to convert an ARM to a fixed rate loan. For loans backed by Fannie Mae, this is limited to $100, or $250 if the ARM includes a monthly conversion option.

Example of ARM conversion option

Rashawn takes out a 30-year 5/1 variable rate mortgage with conversion option, principal of $332,800. The interest rate for the first five years is 4.21%, giving him a monthly payment (excluding home insurance and property taxes) of $1,629.

Approaching the five-year mark, Rashawn learns that his rate will drop to 4.46%, raising his payment to $1,672.

Although it doesn’t have a major impact on his monthly budget, he decides he’d rather have the peace of mind of a fixed payment and chooses to convert his ARM to a fixed rate loan. The fixed-rate loan comes with a higher rate of 5.46%, bringing his monthly payment to $1,881. Although the payment has increased, eliminating the potential for rate increases, Rashawn could end up paying much less interest over 30 years. (He could also maximize this benefit by making an additional capital payment each year.) He’ll also be better able to plan his spending with the predictable payment.

ARM vs Fixed Rate Calculator

Advantages and disadvantages of convertible ARMs

Advantages

  • With a convertible ARM, the borrower has the ability to potentially lock in an even better rate at a specific time in the future.
  • Conversion fees are much lower than closing costs to refinance an ARM into a fixed rate loan. (However, borrowers can refinance at any time if rates drop, while the conversion option is usually only available at the start of the loan term.)
  • As with any ARM, the borrower initially benefits from a lower interest rate and a monthly payment.

The inconvenients

  • The borrower may need to monitor interest rates, which fluctuate daily or even hourly, to see if it is better to switch to the fixed option. (If rates have gone up, the borrower won’t benefit from the conversion.) At best, it’s a time-consuming task.
  • The borrower must pay a nominal fee to convert.
  • As with other types of ARM, a convertible ARM can be risky if the borrower is not prepared for higher monthly payments.

When to buy a convertible ARM

Borrowers can only benefit from a convertible ARM if rates go down – but it’s incredibly difficult to predict five years or even a year from now where rates will go. If you’re comfortable with some risk, a convertible ARM has the advantage of lower monthly mortgage payments, at least for the introductory period. However, other types of ARM have this same functionality, so don’t rule out other options. If you can afford the payments, a fixed rate loan is often the safest route. Remember: if rates go down, you can always refinance your mortgage to a fixed, lower rate.

Comments are closed.