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Convertible adjustable-rate mortgages (ARMs) seem complicated at first glance. However, once you understand the basics, these unique loans make more sense. I’ll explain what a convertible ARM is, how it works, and whether it could be the right mortgage option for you.
What is a Convertible ARM?
A convertible ARM is a type of adjustable-rate mortgage that allows you to convert your loan from an ARM to a fixed-rate mortgage after an initial period, typically 5, 7 or 10 years
With a traditional ARM, your interest rate changes periodically based on an index rate, such as the Secured Overnight Financing Rate (SOFR). Your payments fluctuate up and down with rate adjustments.
A fixed-rate loan keeps the same interest rate and payment amount for the full loan term, often 15 or 30 years. Refinancing is required to get a different rate.
A convertible ARM gives borrowers flexibility You benefit from lower initial rates but can switch to a fixed rate later for payment stability, avoiding a refinance
How Does a Convertible ARM Work?
Convertible ARMs have an adjustable rate for the first 5, 7 or 10 years. After that set period, a conversion option lets you change to a fixed interest rate for the remainder of the loan
You’ll pay a conversion fee, typically around $100 to $500, to switch from an ARM to fixed rate. While not free, this conversion fee costs less than refinancing charges.
Here’s a step-by-step look at how these loans work:
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Initial ARM period: You get an adjustable interest rate for the first 5, 7 or 10 years. Your rate and payment change periodically based on the index.
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Conversion option window: When your initial ARM period ends, you have the option to convert to a fixed rate, usually for a small fee. The conversion window is often brief, such as 60 days.
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Fixed interest rate: If you convert, the loan switches to a fixed interest rate for the remainder of the term. Your principal and interest payment will then remain stable.
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Potential rate increase: The fixed rate after conversion is typically higher than your adjustable rate. But your new rate is fixed rather than fluctuating.
The Pros and Cons of Convertible ARMs
I’ll summarize the key advantages and disadvantages of convertible ARM loans:
Pros
- Lower rates and payments at first
- Avoid refinancing costs to switch to fixed later
- Flexibility if rates fall even lower later
Cons
- Risk of higher payments if rates increase
- Monitoring rates takes effort
- Brief conversion window
- Conversion fee to switch to fixed
Convertible ARMs offer flexibility but aren’t for everyone. Make sure you’re comfortable with the risks before choosing this option.
Who Should (and Shouldn’t) Get a Convertible ARM
Certain borrowers are better fits for convertible ARMs than others:
Good fits:
- First-time homebuyers needing lower initial payments
- Borrowers who expect to move before the ARM period ends
- Borrowers who can monitor rates and conversion windows
Poor fits:
- Borrowers wanting payment predictability
- Borrowers unable to handle payment increases
- Borrowers unable or unwilling to track rate changes
These loans can provide significant payment savings but require financial flexibility. Make sure a convertible ARM aligns with your budget and long-term plans before moving forward.
How to Get a Convertible ARM Loan
If you decide a convertible ARM is right for you, follow these steps:
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Check your credit and improve your score if needed.
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Research lenders offering convertible ARMs. Compare interest rates and fees.
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Choose your top three lender picks and get pre-approved.
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Submit all required documentation for underwriting.
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Accept the loan offer and schedule your closing.
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Carefully review the ARM terms and conversion clause details.
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Sign final loan paperwork and close on your new mortgage.
Be sure to understand the loan terms, index rate, rate caps, conversion fees, and other key details before committing.
Alternatives to Convertible ARM Loans
Convertible ARMs aren’t your only option. Here are a few alternatives to consider:
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Fixed-rate mortgage: Offers stable payments for the full term.
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ARM without conversion: Fluctuating payments but usually lower initial rates.
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FHA loan: Low down payment requirement, fixed or adjustable rates.
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VA loan: No down payment required for qualified borrowers, fixed and ARM options.
Look at all your choices to determine the best mortgage for your situation. Don’t rush into a loan you don’t fully understand or can’t afford long-term.
The Bottom Line
While confusing at first glance, convertible ARMs offer flexible features that could benefit certain borrowers. Lower initial rates provide savings, but payment adjustments and conversion decisions require planning.
Weigh the pros and cons carefully to decide if a convertible ARM is the right loan for your home buying needs and financial circumstances. With the right preparation, you can take advantage of these loans without taking on excessive risk.
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How do convertible ARMs work?
With a traditional ARM loan, after the initial fixed-rate period expires, your interest rate can go up or down at predetermined times (for example, every six months or once a year) based on prevailing market rates. These fluctuating interest rates will either raise or lower your monthly mortgage payment. The rate is based on an index, such as the Secured Overnight Financing Rate (SOFR), and whatever margin that is stated in your loan documents.
In contrast, the interest rate on a fixed-rate mortgage stays the same for the entire loan term, meaning your monthly payments do not change. Many borrowers appreciate this stability in their monthly budget, especially as interest rates tend to trend upward.
With a convertible ARM loan, that same borrower could move from an ARM to a fixed-rate loan without having to go through the refinancing process (and paying its associated closing costs). The caveat is that the rate you’ll get when you convert to a fixed-rate mortgage will likely be higher than your adjustable rate. Mortgage Example of a convertible ARM loan
- Rashawn takes out a 30-year 5/1 adjustable-rate mortgage for $350,000 with a conversion option. The interest rate for the first five years of his convertible mortgage is 6.49 percent, giving him a monthly payment (excluding homeowners insurance and property taxes) of about $2,210.
- Approaching the five-year mark, Rashawn learns his rate will change to 6.69 percent, bumping his monthly payment to about $2,251.
- Rashawn decides he’d rather have the peace of mind of a fixed payment for the remainder of the loan term and opts to convert his ARM to a fixed-rate loan. The fixed-rate loan comes with a higher rate of 6.99 percent, bringing his monthly payment to about $2,326.
Is a 5/1 Adjustable-Rate Mortgage (ARM) a Good Idea?
FAQ
What is a convertible ARM?
What does ARM mean in a loan?
What does convertible mean in mortgage?
When an ARM has a convertibility feature, it means it can be?
What is a convertible ARM loan?
A convertible ARM loan is a hybrid mortgage that combines adjustable-rate mortgages (ARMs) 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.
Can a convertible arm convert to a fixed-rate mortgage?
A convertible ARM can give you the flexibility to convert from an adjustable-rate to a fixed-rate mortgage. However, it’s important to be aware that there’s a cost to doing this and the ARM rate may be higher than you could get with a standard ARM.
What is a convertible arm?
A convertible ARM allows a borrower to change from adjustable to fixed rates after a period of time. Interest rates can rise or fall unpredictably, though, and you can risk getting stuck with a higher rate than you started with.
Are convertible arms a good option when interest rates are falling?
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.