Converting a mortgage from adjustable to fixed

You can get at least two kinds of convertibles. The automotive type is perfect for sunny skies. Then there is something much less sexy: a species of home loan called the convertible adjustable-rate mortgage. It's best suited to borrowers who spy storm clouds on the financial horizon

Convertible ARMs are adjustable-rate mortgages that can be switched to fixed-rate loans for relatively little out-of-pocket expense. You pay for the privilege with either a slightly higher interest rate on the ARM, on the fixed-rate loan, or both.

These loans aren't for everyone. Interest rates on 30-year fixed mortgages are around 6 percent, the lowest in almost 40 years, and if you plan to stay in your home for several years, a long-term, fixed-rate loan could be your best bet.

Convertible mortgages are marketed as a bulwark against rapidly rising interest rates, and there is some merit to that logic. But getting a fixed-rate loan at about 6 percent is excellent protection from rising interest rates, too.

On the other hand, if you expect 30-year fixed mortgage rates to drop within five years, convertible ARMs are worth considering. With fixed rates so low now, it seems unlikely that they will drop appreciably over the next half decade, but it's possible if the economy goes into a deep recession.

And you might look at convertible ARMs if you have a good credit history now but have reason to believe it will deteriorate in the next few years. That could happen if you fail to pay bills on time. It also could happen if your marriage dissolves. Divorce frequently exacts a toll on the credit records of one or both former spouses.

"It's typically not that good an idea" to get a convertible ARM, says Scott Haislet, an accountant, attorney and mortgage lender in Lafayette, Calif. "The only time I think it would be a good idea is if you don't think you could qualify for the best rate in the future."

Haislett does believe that ARMs in general often are a good choice. He himself has an adjustable mortgage, and he routinely recommends them to his clients -- especially those who don't plan to be in their houses for more than five years. But he thinks it's usually not worthwhile to choose an ARM just because it's convertible.

Adjustable-rate mortgages are home loans that have an initial interest rate for a certain period. At the end of that time, the rate changes periodically in relation to some other rate, such as yields on U.S. Treasury notes. A one-year ARM has an introductory rate for one year, then adjusts annually thereafter. A three-year ARM has an introductory rate for three years, then adjusts annually. There are also five-year, seven-year and 10-year ARMs.

ARMs typically have lower initial rates than fixed-rate mortgages. That translates into lower monthly payments. Those lower payments are balanced by the risk that rates -- and payments -- could rise in the future. ARMs have interest rate caps, so rates can't zoom into the stratosphere.

To describe how a typical convertible ARM works, we will go to SunTrust, which is one of many lenders that offers such loans. SunTrust's convertible ARMs are based on the yields on U.S. Treasuries. Recently the rate on a one-year ARM for someone with good credit was 3.625 percent with a 1 percent origination fee -- more than 2 percentage points lower than a 30-year fixed-rate loan.

Converting a mortgage from adjustable to fixed

Starting one year after the borrower gets the ARM, the loan can be converted to a fixed-rate mortgage. It can be converted anytime between the loan's first and fifth anniversaries for a $250 fee.

"They don't have to go through the documentation, they don't have to pay the closing costs and settlement fees and surveys -- they just pay $250 and come out with a fresh loan -- and they're quick," says John Philips, a senior vice president for SunTrust.

The alternative is to refinance with a new loan, replete with hundreds or thousands of dollars in fees.

Converting costs less than refinancing. But you pay a higher rate when you convert. A borrower who converted recently would have got a fixed rate of 6.295 percent; by refinancing (and paying all those closing costs), the borrower would get a fixed rate around 6 percent.

This is where Haislet's advice fits in when he says a convertible ARM might be a good idea for someone who might not qualify for a good rate in the future. A borrower with good credit can get a mortgage at about 6 percent today. Someone with flawed credit would pay a higher rate, and 6.295 percent would be a bargain.

The advantage of a convertible loan, Philips says, "is if the borrower got a low-rate ARM and they got swept into an upward rate market, they have a nice device to fix it before it goes up any farther or before it goes up to a level they can't afford or be comfortable with."

With their low rates, ARMs allow people to buy houses they can't otherwise afford, and they can convert to fixed rates when they have higher salaries and more job security, Philips says.

One of SunTrust's competitors, Home Loan Center, offers ARMs but not convertible ARMs. "We do not see the value in offering a conversion option," CEO Anthony Hsieh says, because he believes it's usually better to refinance.

Nevertheless, Hsieh offers this advice to people who consider getting an adjustable loan with a conversion option: Compare how much various lenders charge to convert. Some, like SunTrust, charge a nominal fee. Others don't charge anything to convert, but levy slightly higher rates. Some work like a refinance, where you pay points and fees.

Hsieh adds that you have to compare the formulas that lenders use to calculate the new fixed rates when you convert. SunTrust adds a "spread" of 0.625 percent over an index called the Fannie Mae 60-day required net yield. When comparison-shopping, ask the lender what the new fixed rate would be if you were converting an ARM today and what fees you would have to pay