What is a convertible ARM loan?

Change your mortgage’s interest rate without refinancing

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With housing prices reaching generational highs, many borrowers are turning to adjustable-rate mortgages (ARMs) to afford their mortgage payments. These loans offer lower interest rates than traditional 30-year fixed-rate mortgages, which can make it easier to buy or refinance a home.

Conventional ARM loans offer the benefits of an adjustable rate with the security of being able to lock in a fixed-rate loan at a later date. Learn more about these loans to decide whether they make sense for your financial situation.


Key insights

Adjustable-rate mortgage (ARM) interest rates fluctuate over time.

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Convertible ARM loans allow homeowners to lock in a fixed interest rate.

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Lenders may charge a fee for converting your ARM to a fixed-rate mortgage.

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Borrowers can lock in a fixed-rate mortgage without refinancing into a new loan.

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How does a convertible ARM work?

A convertible ARM loan works like a regular adjustable-rate mortgage, except borrowers have the option to lock in a fixed rate at a predetermined point in time. Adjustable-rate mortgages (ARMs) offer a lower introductory rate than a traditional fixed-rate mortgage.

Most ARM interest rates are fixed for a set number of years and then adjust periodically based on current interest rates. This means rates could increase or decrease and your mortgage payment will change accordingly.

ARMs commonly have fixed introductory periods of three, five or seven years.

With a convertible ARM loan, you can lock in a fixed interest rate after a certain amount of time has passed. This feature allows you to lock in your mortgage rate before your interest rate and monthly payment balloon as rates increase.

While you can refinance your mortgage at any time, getting a new loan comes with substantial costs. Using your option to fix the rate avoids the cost and hassle of finding a new lender to refinance your mortgage. Most lenders charge a small fee to lock in your new rate, and your existing loan stays in place.

» MORE: ARM vs. fixed-rate mortgage

Example of a convertible ARM

A borrower takes out a convertible ARM loan for $400,000. This 30-year loan features a fixed interest rate of 6.249% for five years, then adjusts every six months. The monthly mortgage payment is $2,463 before property taxes and insurance.

Alternatively, the borrower could take out a 30-year fixed-rate mortgage from a major bank at 7.375%. While this monthly payment is fixed throughout the term of the loan, it is $300 higher at $2,763 per month.

During the five years that the interest rate is fixed, the borrower will pay $18,000 less in monthly mortgage payments with the ARM over the fixed-rate loan.

After three years, the borrower sees that interest rates are rising, and they want to lock in a fixed rate before their intro APR expires. By paying a small fee, they can convert their adjustable-rate mortgage into a fixed-rate loan without having to refinance. This not only saves them the normal closing costs of a mortgage, but they also don't have to worry about qualifying for a new loan because the conversion has no impact on their credit.

Pros and cons of convertible ARMs

Like most loan programs, there are pros and cons for using a convertible ARM loan to buy or refinance your home. Before pursuing this mortgage product, consider the impact it will have on your finances.

Pros

  • Introductory interest rate that is below fixed-rate mortgages
  • Typically offers a fixed rate for a number of years before the first adjustment
  • Conversion option avoids the cost of refinancing when locking in a fixed rate

Cons

  • Not all lenders offer convertible ARM loans
  • Lenders typically charge a fee to convert to a fixed-rate
  • May have to wait a minimum period before you can convert your loan

When should you get a convertible ARM?

While 92% of homebuyers select a fixed-rate mortgage, a convertible ARM loan is a good option for people who want the lower rate of an adjustable-rate mortgage while having the peace of mind of being able to lock in a fixed rate at some point in the future.

Dan Green, the CEO of HomeBuyer.com, said that "homebuyers should consider a fixed-rate mortgage if they plan to retain the loan for more than 5-7 years."

Getting a convertible ARM is a solid choice if you're unsure of how long you'll live in your home. The lower interest rate of the ARM saves money in the short term with a smaller monthly payment. Then, if you decide to stay in the home past the introductory fixed interest rate, you can either let the rate adjust or convert to a fixed rate based on mortgage interest rate trends.

Mortgages with adjustable rates typically offer lower rates than fixed-rate loans, so it is easier to get approved and the loan payments are more affordable. As your disposable income increases and you can afford a fixed rate, convert your ARM and lock in your monthly payment.

Getting a convertible ARM also makes sense when interest rates are falling. These loan types allow you to benefit from a lower rate right away, then lock in a fixed-rate mortgage at some point in the future as rates go down. Keep in mind that the direction and depth of interest rate changes can alter course quickly, so betting on this strategy can be risky.

When there is a minor difference in interest rates between a fixed-rate mortgage and a convertible ARM loan, it may make sense to lock in the interest rate. While you'll pay a little more for the convenience of a fixed interest rate, you'll avoid the stress of wondering how interest rates will change in the future.

How to get a convertible ARM

The process for getting a convertible ARM loan is the same as any other type of mortgage. You'll need to complete an application, submit supporting documentation and respond quickly to requests from the underwriter or loan officer. Follow these steps if you're interested in applying for a convertible adjustable-rate mortgage:

  1. Review your credit report to identify errors or problem accounts, then take steps to address them.
  2. Determine your loan amount, down payment (if buying a home) and how much you can afford to pay each month.
  3. Compare lenders to find the best interest rate, fees and terms for your mortgage.
  4. Gather your financial information and be ready to provide supporting documents to your lender. You should be prepared with:
    1. Financial documents including two months of pay stubs, the last two years of tax returns and W-2s, and your most recent bank and investment account statements.
    2. If you own your home, you'll also need property tax, home insurance and HOA dues statements (if applicable).
    3. For homebuyers, provide the purchase agreement if you're under contract and estimates for property taxes, homeowners insurance and HOA dues (if applicable).
  5. Submit your loan application.
  6. Discuss loan options with the lender and choose how long to lock in your interest rate.
  7. Reply to the loan officer and underwriter quickly and provide all supporting documentation requested.
  8. Coordinate with your loan officer to review and sign your mortgage documents to finalize your loan.

Keep in mind that you can apply for a mortgage even if you don't own a home or have a home under contract. Having a pre-approved mortgage can make your offer stand out among other buyers that the seller is considering.

During the underwriting process, avoid any additional credit inquiries or large purchases that can affect your credit.

View rates from leading lenders now.

    FAQ

    What is the conversion clause in an ARM?

    The conversion clause of a convertible ARM loan allows the borrower to convert their mortgage from a variable rate to a fixed rate. The window for this change varies by lender, with some requiring a waiting period before you can activate this feature and others offering this benefit for a limited time.

    Lenders may charge a fee when converting the loan, but these fees are typically much less than the cost to refinance.

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

    A standard adjustable-rate mortgage (ARM) has a variable interest rate once the initial fixed interest rate expires. The rate adjusts based on economic conditions up to periodic and lifetime maximum allowed changes (otherwise known as an interest rate cap).

    A convertible ARM loan operates the same way but includes an option for the borrower to convert from a variable to a fixed rate during the loan term.

    When does a convertible ARM change to a fixed rate?

    Convertible ARM loans do not change to a fixed-rate loan until the borrower submits a request. Most lenders charge a small fee to lock in a fixed rate, but this fee is usually substantially less than what it would cost to refinance your home.

    Keep in mind that many lenders require a waiting period before you can activate the conversion option, while others allow conversions only during the early years of the mortgage term.

    What is a good interest rate on a mortgage?

    Mortgage interest rates change regularly based on economic conditions, housing demand and lender competition. In April 2024, a good interest rate for a fixed-rate loan is in the 6.50% to 7.50% range. Adjustable-rate mortgage rates are lower by at least 0.50% to 0.75%.

    Bottom line

    Adjustable-rate mortgages (ARM) offer initially lower interest rates than traditional fixed-rate mortgages. However, when interest rates adjust, affordable mortgage payments can quickly become budget-busters that can lead to financial distress.

    For this reason, some borrowers choose convertible ARM loans to get the benefit of lower interest rates and the ability to lock in a fixed rate in the future. This feature can provide peace of mind for borrowers who are concerned about being priced out of their homes.


    Article sources
    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
    1. Realtor.com, "What Is a Convertible ARM? The Pros, Cons, and When It Makes Sense To Get One." Accessed April 25, 2024.
    2. Experian, "What Is a Convertible ARM Loan?" Accessed April 25, 2024.
    3. Members Choice Credit Union, "FlexChoice Convertible Mortgage." Accessed April 25, 2024.
    4. Investopedia, "Convertible ARM: Meaning, History, Drawbacks." Accessed April 25, 2024.
    5. Jewett City Savings Bank, "Convertible Adjustable Rate Mortgage (ARM)." Accessed April 25, 2024.
    6. Citizens Equity First Credit Union (CEFCU), "Mortgage Rates." Accessed April 25, 2024.
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