Convertible ARM loans: What they are and how they work

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A convertible adjustable-rate mortgage (ARM) can be an appealing option for first-time homebuyers looking for lower initial interest rates and monthly payments. However, it’s not the right choice for everyone. Here’s what you need to know about a convertible ARM and how it works.

What is a convertible ARM?

A convertible adjustable-rate mortgage allows the borrower to change from an adjustable rate to a fixed one after the initial fixed-rate period expires without refinancing. You might also hear this option called a conversion clause or part of a conversion option mortgage.

If you choose to convert your mortgage when the introductory rate period ends, usually after five, seven or 10 years into the loan term, you typically have to pay a small fee to use this option. That said, you can benefit from receiving a set interest rate for the loan’s remaining duration, which means more stable, predictable monthly payments.

How do convertible ARMs work?

With a traditional ARM loan, after the initial fixed-rate period expires, your interest rate can go up or down at predetermined times (for example, every six months or once a year) based on prevailing market rates. These fluctuating interest rates will either raise or lower your monthly mortgage payment. The rate is based on an index, such as the Secured Overnight Financing Rate (SOFR), and whatever margin is stated in your loan documents.

In contrast, the interest rate on a fixed-rate mortgage stays the same for the entire loan term, meaning your monthly payments do not change. Many borrowers appreciate this stability in their monthly budget, especially as interest rates tend to trend upward.

With a convertible ARM loan, that same borrower could move from an ARM to a fixed-rate loan without having to go through the refinancing process (and paying its associated closing costs). The caveat is that the rate you’ll get when you convert to a fixed-rate mortgage will likely be higher than your adjustable rate.

Example of a convertible ARM loan

Here’s an example of how a convertible ARM loan might work:

• Rashawn takes out a 30-year 5/1 adjustable-rate mortgage for $350,000 with a conversion option. The interest rate for the first five years of his convertible mortgage is 6.49 percent, giving him a monthly payment (excluding homeowners insurance and property taxes) of about $2,210.
• Approaching the five-year mark, Rashawn learns his rate will change to 6.69 percent, bumping his monthly payment to about $2,251.
• Rashawn decides he’d rather have the peace of mind of a fixed payment for the remainder of the loan term. He opts to convert his ARM to a fixed-rate loan using the conversion clause with his mortgage. The fixed-rate loan comes with a higher rate of 6.99 percent, bringing his monthly payment to about $2,326.

History of convertible ARMs

Convertible ARMs came into play in the early 1980s when fixed-rate mortgages had high interest rates that made for expensive payments. At the time, many borrowers took the chance on convertible ARM loans because it seemed unlikely that rates would continue to increase, and therefore they’d benefit from a lower interest rate if rates declined after the set fixed-rate period.

When Fannie Mae and Freddie Mac started to purchase convertible ARM loans on the secondary mortgage market in the 1980s and 1990s, these home loans became more affordable and accessible.

Pros and cons of convertible ARMs

These loans come with attractive features, but they are not without potential downsides. Weigh the pros and cons of a convertible ARM loan to determine if it’s right for you.

How to get a convertible ARM

If you decide to apply for a convertible ARM, here’s how to move forward:

1. Check your credit to see where you stand and determine if you’re a good fit for a loan.
2. Research lenders to find those offering convertible ARMs.
3. Narrow down your list to the three most reputable options.
4. Get preapproved and compare loan offers, including mortgage rates and fees, to find the best offer.
5. Begin your search for a home that fits your budget.
6. Formally apply for a convertible ARM and select the option with the initial fixed-rate period that works for you.
7. Submit your chosen lender’s requested documentation promptly to expedite the mortgage underwriting process.
8. Receive your final approval, read the fine print to confirm you understand the conversion clause and close on the loan.

Should you get a convertible ARM?

Some borrowers take out an ARM loan 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 into a home for less. The hope is that their income will increase or rates will come down enough that they’ll be able to convert to a fixed-rate loan before the ARM rate resets. However, this comes with considerable risk.

“The purpose of convertible ARMs is to take advantage of falling rates, so if rates rise, there’s really no benefit with them,” says Linda Bell, principal writer for Bankrate. “After a specified term, you can convert your loan. The question is, will the rate be higher or lower than your initial rate? If the rate is lower, you made a smart move. If it’s higher, the conversion doesn’t make sense. You will likely be paying more.”

If you’re comfortable with the risk, a convertible ARM loan comes with the upside of lower monthly mortgage payments, at least for the introductory period. And if rates start to tick up, it gives you the option to convert your interest rate to a fixed one, assuming you’re willing and able to pay the conversion fee.

Convertible ARM FAQ

• What are alternatives to convertible ARM loans?

  If you can afford the higher payments, a fixed-rate loan can be the safer alternative because of the predictable payments it provides. Don’t forget: If rates go down, you can always refinance to a lower, fixed-rate mortgage.

• What is the conversion clause fee?

  A conversion clause allows the mortgage lender to convert an ARM to a fixed-rate loan, and the conversion clause fee is what they charge to do so. For Fannie Mae-backed loans, this is limited to $100, or $250 if the ARM includes a monthly conversion option.

• What’s the difference between an ARM and a convertible ARM?

  An ARM and a convertible ARM are similar, but the main difference is that with a convertible ARM, you won’t need to refinance and pay closing costs to switch to a fixed-rate loan. Convertible ARM loans have a conversion clause that allows the borrower to swap their rate and skip the refi process.

• Who is eligible for a convertible ARM?

  To be eligible for a convertible ARM loan, you typically need to meet conventional ARM loan requirements, such as a credit score of at least 620. For an FHA ARM loan, the minimum drops to 580. You must also meet debt-to-income ratio standards (usually no more than a 50 percent ratio) and down payment requirements (at least 3 percent for conventional loans and 3.5 percent for FHA loans).