Convertible ARM Loan: Is It Right For You?
Miranda Crace4-minute read
November 02, 2020
Finalizing a mortgage is a major commitment, and after coming up with the funds for your down payment, you might be wondering how to get the best deal on your interest rate. Is it better to choose a steady rate or to move with market rates? A convertible ARM loan promises you the ability to do both.
What Is A Convertible ARM Loan?
A convertible ARM loan is a hybrid mortgage that combines adjustable rate mortgages and fixed-rate mortgages. Borrowers begin their loan term with an adjustable interest rate, but after a set period of time, they have the option to convert to a fixed rate. Home buyers who choose convertible mortgages often do so in an attempt to reap the benefits of potentially falling interest rates early in the life of the loan before settling in to a secure, unchanging monthly payment.
How A Convertible ARM Works
The exact conditions of a convertible ARM loan will vary depending on the lender, but the basic structure of the mortgage has two main parts: the initial, traditional ARM and the conversion to a conventional mortgage.
Begin With An Adjustable-Rate Mortgage
An adjustable-rate loan has a variable interest rate that changes with the market, and this is exactly how your mortgage will initially behave if you choose a convertible ARM.
Your initial interest rate – called a teaser rate – will usually be quite a bit lower than the standard fixed rate. After a set period, the teaser period will end and your rates will change periodically according to an index, like LIBOR or the 12-month Treasury bill rate, and a margin.
Before signing on any ARM, you should take into consideration any monthly payment caps that could result in negative amortization on your loan.
Convert To A Fixed-Rate Mortgage
After a set period of time, often 1 – 5 years, you'll have the option to convert your ARM loan into a conventional fixed-rate loan. In other words, you'll be able to settle into a single rate for the rest of the life of your loan. While you won't pay closing costs on your conversion, there is generally an associated fee.
Your new rate is determined based on the lowest rate within a week of your final decision to convert. If rates are falling, this means 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 somewhat higher than what you initially paid on your ARM.
The Pros and Cons Of A Convertible ARM
Like many alternative mortgage loans, there are advantages and disadvantages to the convertible ARM. Exploring a few of them can help you decide whether this is the right mortgage for you.
The major incentive of a convertible ARM is that it has the potential to get you a better interest rate than what is currently available.
For example, suppose the current interest rate is 3.5%. You may want to purchase a house now, but you believe interest rates will fall in a few years. Rather than wait for that to happen, you can choose to sign a convertible mortgage now. A few years down the road, when rates have dropped to 2%, you can convert to a fixed-rate mortgage with a lower interest rate than you would have gotten when you initially purchased your home.
Additionally, initial rates for convertible ARMs are usually much lower than for fixed rates. In the above example, this might mean securing an initial rate of 2.8% rather than the standard 3.5%. A convertible mortgage also allows homeowners to take advantage of variable rates without needing to refinance later on.
Convertible ARMs first arose with Fannie Mae and Freddie Mac in the 1980s, when interest rates were so high they were all but guaranteed to fall. Taking on an adjustable rate for a short period of time had a good chance of paying off later on.
However, this means these loans are only valuable if interest rates do indeed fall. 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, you might have to settle for a loss if you want to lock in a stable monthly mortgage payment.
Is A Convertible ARM Right For You?
While the convertible ARM can capture the benefits of both adjustable and fixed rates, you must be willing to take on some risks to reap those benefits. If you're not comfortable with an element of chance, a convertible mortgage is probably not the right home loan choice for you.
Predicting the movement of interest rates is a challenge even for the experts, but if you're comfortable playing the odds and taking calculated risks, and you've assessed your particular financial situation, you might consider a convertible ARM when looking over your mortgage options.
While Rocket Mortgage® does not currently offer convertible ARMs, if you're looking for the right mortgage to fit your particular needs, we can help search your options and get custom recommendations for loans that let you see exactly what your payments and interest rates will be.
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