Convertible ARM loan: Is it right for you?

The interest you pay on a mortgage can be calculated in a few different ways. Fixed-rate mortgages lock in one interest rate for the entire loan term, keeping your monthly payment steady. Adjustable-rate mortgages (ARMs) lock in a lower rate for a specific time, then change with market rates and may increase your monthly payment. A convertible ARM combines both: You start with an ARM and later switch to a fixed-rate loan. You may be thinking a loan with a convertible mortgage rate offers the best of both worlds, but there are risks to this type of loan.

While Rocket Mortgage doesn’t offer convertible ARMs, here’s how they work, their pros and cons, and how to tell if one fits your goals. Learn more about convertible mortgage loans and different types of mortgages.

What is a convertible ARM loan?

A convertible ARM begins like a regular ARM. After a set period of time, you can convert your ARM to a fixed-rate mortgage.

Convertible ARMS appeal to buyers who want to benefit from potentially falling mortgage interest rates early in the life of the loan, before settling into a secure, unchanging monthly payment.

“This structure can appeal to borrowers who want a lower rate and payment up front as well as the flexibility to lock in more predictability later if rates rise or their financial goals change,” says Dennis Shirshikov, a professor of finance and economics at City University of New York-Queens College.

How a convertible ARM works

The exact terms of a convertible ARM loan are up to the lender. However, the basic structure has two main parts: the initial traditional ARM and the conversion to a conventional mortgage.

Let’s take a deeper dive into both parts.

1. Begin with an ARM

An ARM offers a fixed introductory rate that's usually lower than that of a comparable fixed-rate loan. The introductory rate lasts for a set number of years, after which your mortgage rate will adjust at specific intervals according to market conditions. Most ARMs have rate caps that limit how much your rate can change at any one adjustment, as well as set an overall rate limit.

The benefit is the lower introductory rate, but your interest rate and your monthly mortgage payment may increase. Before committing to an ARM, make sure you can afford the higher mortgage payment.

2. Convert to a fixed-rate mortgage

After a set period, typically within the first 10 years, you can convert your ARM to a conventional fixed-rate loan. In other words, you’ll be able to settle into a single rate for the remaining life of your loan. While you typically won’t pay closing costs on your conversion, there is usually an associated fee.

Your new rate will be determined by the available rates at the time you convert. If rates are falling, you'll get a lower interest rate than you might otherwise have received. There are usually specific conditions from loan to loan. But in virtually all cases, the fixed rate you receive after converting will be higher than what you initially paid on your ARM.

Pros and cons of a convertible ARM

There are advantages and disadvantages to a convertible ARM.

Pros

• You don't have to try to time the market. If you expect interest rates to fall, a convertible mortgage allows you to secure a home at current rates while maintaining the flexibility to switch to a lower fixed rate later. This strategy enables you to purchase immediately and convert later to a more favorable rate once market conditions improve.
• Initial interest rates are lower than fixed rates. "A convertible ARM can often charge 0.5% to 1% below comparable fixed-rate mortgage loans, which means lower monthly payments in the early years,” says Andrew Lokenauth, a personal finance expert in Tampa, Florida.
• Interest rates may further drop just before you lock in. You can keep an eye on the market and wait for the ideal moment to switch. If rates decline after you've already started your loan, you can lock in that lower rate, saving you much more over the life of the loan.
• You may not need to refinance later. The option to switch to a fixed rate is already part of your original loan, so you can avoid the hassle of a traditional refinance. That means you can sidestep the worry of closing costs, paperwork, or paying for another home appraisal.
• Your DTI may improve. Because the initial interest rate on a convertible ARM is lower than a fixed-rate loan, your monthly mortgage payment starts out lower. During underwriting, this reduces your DTI, which can be the deciding factor in getting your loan approved. It also may help you qualify for a larger mortgage because less of your monthly income is tied up in the house payment.

Cons

• Rates may not be low enough when it’s time to convert. While you can attempt to predict what will happen, the real estate market can be unpredictable. If conversion time comes and rates continue to rise, converting your loan may result in a loss.
• The timing may be bad. Your conversion window is limited, and missing this window leaves you with an adjusting rate. "If rates go up before you convert, your monthly payment can jump by hundreds of dollars,” Lokenauth says.
• There are conversion limits. “There can also be limits on how and when the conversion can happen, which means you need to fully understand the contract details rather than assuming it’s a simple switch at any time,” Shirshikov says.
• Expect to pay fees. You'll bypass the closing costs of a traditional refinance, but you'll likely still pay a conversion fee of a few hundred to $1,000 or more.
• You’re locked into your amortization schedule. Staying on your original amortization schedule can be a plus, but it can also be a drawback. With a traditional refinance, you usually reset to a new 30-year term to decrease your monthly payment. But with a conversion, you're commonly locked into your original timeline. For example, if you are 5 years into a 30-year loan, your new fixed payment will be calculated over the remaining 25 years, which could result in a higher monthly payment than a fresh 30-year refinance would provide.

Is a convertible ARM the right mortgage for you?

While a convertible ARM features the benefits of both adjustable- and fixed-rate loans, you must accept some risk to realize those benefits.

“A convertible ARM makes the most sense for buyers who expect their income to grow, plan to move or sell within 5 to 7 years, or believe fixed rates will fall in the near future,” says Lokenauth. “But this is a poor fit for anyone who values certainty above all else or who plans to remain in their home for many years.”

The bottom line: Convertible ARM loans offer low intro rates

A convertible ARM gives borrowers the option to switch from an adjustable-rate to a fixed-rate loan. Interest rates can rise or fall unpredictably, though, and you can risk getting stuck with a higher rate than you started with. If you're comfortable playing the odds and taking calculated risks, and you've assessed your financial situation, consider a convertible ARM among your mortgage options.

Rocket Mortgage doesn't currently offer convertible ARMs. But if you're looking for a different mortgage option that fits your needs, start the approval process today and see what your payments and interest rates might be with different loan types.