A convertible adjustable-rate mortgage (ARM) is a type of home loan that allows the borrower to change the structure of the interest rate after a certain 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 change their ARM loan to a fixed-rate loan after a period of time, usually for a fee. This option typically kicks in any time from one year into the loan to five years in.
With an ARM, the borrower’s interest rate can go up or down at predetermined times (for example, every six months or once a year) based on prevailing market rates, which either increases or decreases the borrower’s 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.
With a fixed-rate mortgage, the rate doesn’t change for the life of the loan, meaning the borrower’s monthly payments stay the same. Many borrowers appreciate this stability in their monthly budget. With the alternative, they’d need to 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 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 refinance to a fixed-rate loan before the ARM rate resets. This is a calculated risk, however.
The catch with a convertible ARM: If interest rates rise, the inclusion of a conversion clause really has no benefit for the borrower. A convertible ARM only works in the borrower’s favor if rates go down — a very difficult outcome to predict.
Conversion clause fee
Mortgage lenders typically charge a fee for the ability to convert an ARM to a fixed-rate loan. For Fannie Mae-backed loans, this is limited to $100, or $250 if the ARM includes a monthly conversion option.
Example of an ARM conversion option
Rashawn takes out a 30-year 5/1 adjustable-rate mortgage with a conversion option, principal of $332,800. The interest rate for the first five years is 4.21 percent, giving him a monthly payment (excluding homeowners insurance and property taxes) of $1,629.
Approaching the five-year mark, Rashawn learns his rate will change to 4.46 percent, bumping his payment to $1,672.
While this 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 opts to convert his ARM to a fixed-rate loan. The fixed-rate loan comes with a higher rate of 5.46 percent, bringing his monthly payment to $1,881. While the payment has gone up, by eliminating the potential for a rate increase, Rashawn could end up paying far less in interest over 30 years. (He could maximize this benefit further by making an extra principal payment each year, as well.) He’ll also be better able to plan for expenses with the predictable payment.
Pros and cons of convertible ARMs
- With a convertible ARM, 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 much lower than the closing costs to refinance out of 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.
- 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.
When to get a convertible ARM
Borrowers can only benefit from a convertible ARM if rates fall — but it’s incredibly tough to predict five years or even one year from now where rates will go. If you’re comfortable with some risk, a convertible ARM comes with the upside of lower monthly mortgage payments, at least for the introductory period. Other types of ARMs have this same feature, however, so don’t rule out other options. If you can afford the payments, a fixed-rate loan is often the safer route. Don’t forget: If rates go down, you can always refinance to a fixed, lower-rate mortgage.