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A convertible ARM loan is a cross between a fixed-rate mortgage and an adjustable-rate mortgage (ARM). The goal is to take advantage of the benefits of both. These hybrid mortgage loans make the most sense when interest rates are falling, but they aren't without risk. Here's how convertible ARM loans work so you can figure out if they're a good fit for you.
What Is a Convertible ARM Mortgage Loan?
With a fixed-rate mortgage, the interest rate stays the same for the life of the loan. ARMs are different in that interest rates periodically change based on current market conditions and your loan's terms. They generally begin with a low-rate period, then adjust at predetermined intervals.
A convertible ARM loan is a mix between these two types of mortgages. It starts off as an ARM, usually with a low-rate introductory period—typically one to five years. When that period ends, borrowers can either keep their loan as is and have an adjustable rate going forward or convert the mortgage and get a permanently fixed rate for the remainder of the loan.
How to Get a Convertible ARM Loan
The specifics tend to vary from lender to lender, but below are the basic steps of the convertible ARM loan process.
1. Get an Adjustable-Rate Mortgage with a Conversion Option
Most adjustable-rate mortgages begin with a locked-in interest rate that's lower than current rates for a fixed mortgage. This fixed-rate period usually lasts five, seven or 10 years. After that, the interest rate will periodically fluctuate for the rest of the loan term. This can be good news when rates are falling, but the opposite is also true. Higher rates will boost your mortgage payment, though there are caps on how much it can increase.
Rate adjustments are calculated using a benchmark rate that's tied to an index such as the U.S. prime rate. The lender adds a certain number of percentage points to that rate to come up with each new rate adjustment. These details should be outlined in your loan estimate.
2. Convert to a Fixed-Rate Mortgage
With a traditional ARM, borrowers who want to lock in a fixed rate when the introductory period ends must refinance—not so for convertible ARMs. They allow you to simply convert your rate structure without paying closing costs, which usually total 2% to 5% of the loan amount. A conversion fee is standard but varies from lender to lender. If you have a home loan backed by Fannie Mae, for example, it's capped at $250 for ARMs that have a monthly conversion option and $100 for all others.
Converting to a fixed rate is beneficial when market rates are favorable to borrowers. It's possible to secure a new rate that's comparable or only slightly higher than your introductory rate. But convertible ARMs could end up costing you more over the long run if rates go up. Case in point: In 2020, average mortgage rates for a 30-year fixed-rate mortgage were just 2.66%, according to Freddie Mac. In contrast, the average rate at the time of this writing is 6.92%.
Once the introductory period ends, borrowers can choose to convert their home loan to a fixed-rate mortgage or move forward with an adjustable rate. It's wise to read the fine print to make sure you understand how rates and adjustment periods are structured.
Pros and Cons of a Convertible ARM Loan
- The introductory period usually offers a lower interest rate when compared to fixed-rate mortgages.
- There are no closing costs to convert the mortgage to a fixed-rate loan.
- Borrowers can benefit from lower long-term costs if interest rates stay reasonable.
- They're only valuable if interest rates fall or at least stay compatible with your budget. It's impossible to predict future rates, so it's inherently risky.
- If rates go up, borrowers will be stuck with a higher mortgage payment.
The Bottom Line
A convertible ARM loan offers an introductory period that usually has a fixed, low rate. After that, homeowners can convert their loan and lock in a new fixed rate, or they can go forward with a rate that adjusts periodically. There are pros and cons to both options. The right decision for you will depend on your financial situation and risk tolerance.