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Kacie Goff is a personal finance and insurance writer with over seven years of experience covering personal and commercial coverage options. She writes for Bankrate, The Simple Dollar, NextAdvisor, Varo Money, Coverage, Best Credit Cards and more. She's covered a broad range of policy types — including less-talked-about coverages like wrap insurance and E&O — and she specializes in auto, homeowners and life insurance.
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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.
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.
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.
Here’s an example of how a convertible ARM loan might work:
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.
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.
If you decide to apply for a convertible ARM, here’s how to move forward:
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.
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.
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.
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.
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).
Arrow Right Personal Finance Contributor
Kacie Goff is a personal finance and insurance writer with over seven years of experience covering personal and commercial coverage options. She writes for Bankrate, The Simple Dollar, NextAdvisor, Varo Money, Coverage, Best Credit Cards and more. She's covered a broad range of policy types — including less-talked-about coverages like wrap insurance and E&O — and she specializes in auto, homeowners and life insurance.
