Convertible ARM loans: What they are and how they work

A convertible adjustable-rate mortgage (ARM) allows the borrower to swap their interest rate from adjustable to fixed once an initial fixed-rate period expires without the need to refinance. You might also hear this option called a conversion clause or part of a conversion option mortgage.

This type of home loan typically comes with lower introductory mortgage rates and payments, making it an appealing option for first-time homebuyers. However, it doesn’t come without risk. See if a convertible ARM loan is right for you.

What is a convertible ARM?

If you choose to convert your mortgage when the introductory rate period ends, you typically have to pay a small fee to exercise this option. That said, you can benefit from receiving a set interest rate for the loan’s duration, which means more stable, predictable monthly payments.

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.

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 that 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.

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.

Pros of convertible ARMs

• With a convertible ARM loan, the borrower has the flexibility to potentially lock in an even better rate at a specific time in the future.
• The fee to convert is less than the closing costs to refinance from an ARM to a fixed-rate loan. (However, borrowers can refinance at any time if rates go down, whereas the conversion option is usually only available early in the loan term.)
• As with any ARM, the borrower benefits initially from a lower interest rate and monthly payment.

 Cons of convertible ARMs

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

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 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.

But borrowers can only benefit from an ARM if rates fall — and it’s difficult to predict where rates will be in five years or even one year from now.

If you’re comfortable with some 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).