Here’s how to navigate what can be a complicated route to homeownership.
What is a convertible mortgage?
A convertible mortgage is an adjustable-rate loan that gives the borrower the option to convert the loan to a fixed-rate mortgage. This type of mortgage began in 1983, when mortgages were very high and Freddie Mac saw this as a way to give homebuyers a chance to lock in lower rates should rates fall.
A convertible mortgage starts as an adjustable-rate mortgage — or a home loan that has a variable interest rate. The rate is dictated by a standard financial index such as the London Interbank Offered Rate (Libor) and the 12-month Treasury bill rate.
One of the drawbacks of adjustable-rate mortgages is that when the index increases, the payment also rises. There are limits that dictate how much the rate can jump over the lifetime of the loan and how much it can change at a single reset.
Homebuyers who have a nonconvertible adjustable-rate mortgage may decide to refinance their loan to avoid steep payment increases.
The key factor for a convertible mortgage is that it lets the borrower lock in an attractive interest rate by agreeing to pay a fee. After the fee is paid, the loan converts to a fixed-rate mortgage. Many lenders have rules that dictate at what point in the loan the borrower can convert the mortgage.
Convertible mortgage example
Robert and Linda have the option of taking out a convertible mortgage to buy a home with a $150,000 mortgage. The initial interest rate is 3 percent. When the payment resets, the interest rate moves to 4 percent.
Robert worries that interest rates will continue to rise, so he decides to pay the fee and convert the mortgage to a fixed-rate loan.