What Is a Convertible ARM? The Pros, Cons, and When It Makes Sense To Get One

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If you remember the housing crisis of 2008, you’ve likely heard the term “adjustable-rate mortgages,” or ARMs. But have you ever heard of a convertible ARM?

ARMs, in general, are once again catching the eye of prospective homebuyers facing unpredictable mortgage interest rates and home prices. Why? Because ARMs boast low introductory “teaser” rates, making them an attractive and affordable option for prospective homebuyers who can’t swing today’s higher interest rates and monthly payments.

The adjustment part of an ARM, where rates can rise or fall, can be risky. A spike in rates once the teaser expires means higher monthly payments down the road.

And what happens if interest rates plummet? That’s where a convertible ARM comes in. Here’s what you need to know to decide if this type of mortgage is a good option.

What is an adjustable-rate mortgage?

Let’s revisit ARM basics. ARMs are hybrid mortgages that offer an attractive, low fixed rate for an introductory period followed by an adjustable-rate period.

The fixed-rate introductory period usually lasts five, seven, or 10 years. After that, the interest rate periodically fluctuates, usually every six months or once a year for the rest of the loan term.

So once the introductory period ends, an ARM’s rates and monthly payments could go up—or down—depending on the market.

You are somewhat shielded from skyrocketing rates with periodic or lifetime caps limiting the rate amount. And with an ARM’s initial interest rate considerably lower than a standard fixed-rate mortgage, it can be an affordable option to leap into homeownership.

In addition, locking in a low rate can be a good option for buyers who plan to sell or refinance their home before the adjustable-rate period begins.

What’s the difference between an ARM and a convertible ARM?

After the introductory period ends, borrowers with a standard ARM looking to lock in a predictable fixed rate must refinance. This change typically comes with refinancing costs of about 2% to 5% of the loan.

But with convertible ARMs, the borrower skips the refinance process and doesn’t have to pay closing costs.

“Convertible ARMs have a clause that allows the borrower to change from an ARM to a fixed-rate mortgage,” explains Chuck Meier, senior vice president and mortgage sales director at Sunrise Banks. “A borrower usually gets the lowest rate offered within a week of signing on the converted loan.”

And so, the conversion fees that come with making the leap from an adjustable-rate to a fixed-rate mortgage are significantly less than the costs associated with refinancing. For example, a home loan backed by Fannie Mae is capped at $250 for ARMs with a monthly conversion option and a $100 cap for all others.

Timing is another factor for homebuyers to keep in mind.

“Usually, borrowers with a convertible ARM will need to switch to a fixed rate within a certain time frame,” says Meier. There are generally three dates your lender sets forth when you can make the jump.

When a convertible ARM makes sense

Convertible ARMs are a good option when interest rates are falling. Since borrowers initially score a lower rate and monthly payment with the loan, they can use the money they save from making lower monthly payments to pay down debt or throw some cash toward the loan’s principal.

“Convertible ARMs are great when you want a low starter rate for your first five years and know that fixed mortgage rates will be doable on one of your first three adjustment dates,” says Dan Green, president at Homebuyer.com, a mortgage company for first-time homebuyers.

And with a convertible ARM, it’s possible to lock in an even better rate at a specific time in the future.

When a convertible ARM doesn’t make sense

As with all types of ARMs, a convertible ARM can be risky if you don’t prepare for a future hike in monthly payments.

Even if your lender approves you for a convertible ARM based on your ability to pay back the loan with the highest capped rates in mind, life is full of surprises. For example, an unexpected drop in your income or medical expenses could make it harder to make loftier payments after the teaser period ends.

And the structure of a convertible ARM can be complex and limiting for borrowers.

“Convertible ARMs can only be switched into a fixed-rate mortgage with the original issuing lender, and usually on the first three adjustment dates only,” adds Green.

The bottom line

Convertible ARMs benefit borrowers in the long run if the interest rates fall. And it’s almost impossible to predict what interest rates will be in one year, let alone five years down the road.

And even with caps limiting how much interest rates can increase, even a 1% rise can significantly affect your monthly mortgage payment.

“You should consider how often a convertible ARM rate can adjust after the initial rate period is over,” says Meier. “Does it adjust monthly, every six months, or annually?”

However, when rates spike, there isn’t any benefit to a convertible ARM.

“The better, more flexible option is to use a standard ARM and retain the flexibility to refinance anytime you want,” adds Green.

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