What is a Convertible Loan?
A Convertible Mortgage is an adjustable-rate mortgage (ARM) that allows the borrower to convert to a fixed-rate mortgage once a certain amount of time has passed. Convertible ARMs are sold as a method to profit from declining interest rates, but they generally come with stipulations. Switching from an ARM to a fixed-rate mortgage usually incurs a cost from the financial institution.
Convertible Mortgage Definition
A convertible mortgage, often known as an adjustable-rate mortgage (ARM), is a loan with an interest rate that is regularly altered based on an index that represents the cost of borrowing on the credit markets to the lender. The lender’s regular variable rate/base rate may be applied to the loan. Although there may be a direct and legally defined relationship to the underlying index, the rate can be altered at the lender’s discretion if there is no particular link to the underlying market or index.
While “adjustable-rate mortgage” is the most popular term in the United States, it refers to a mortgage that is controlled by the federal government and has charge limitations. Adjustable rate mortgages are the standard in many nations, and they are simply referred to as mortgages there.
How does a Convertible Mortgage work?
When applying for a mortgage, there are several options to consider, most of which have to do with how the interest rate is calculated during the life of the loan. Convertible ARMs combine the features of a traditional fixed-rate 30-year mortgage with the flexibility of an adjustable-rate mortgage. Fixed-rate mortgages provide borrowers the peace of mind of knowing that their monthly payment will never vary, even if interest rates rise, which is a prudent and safe strategy. The payouts essentially decrease in relation to inflation over time.
An adjustable-rate mortgage (ARM) starts with a significantly lower introductory teaser rate, but after a defined period (usually five years), the rate is modified based on an index, such as the Secured Overnight Financing Rate, plus a margin. Every six months, the rate is modified and might go up or down.
A convertible ARM starts out as a 30-year adjustable-rate loan, with a teaser rate that is lower than the market average. However, the borrower has the opportunity to convert to a fixed rate after a certain amount of time, usually after the first year but before the fifth year. The new interest rate is generally the lowest rate available within the seven days leading up to the lock-in date. As a result, if interest rates are falling, the borrower may be able to receive a lower fixed rate than they may have gotten previously.
Convertible Mortgage Conclusion
Marketed as a way to take advantage of falling interest rates, the convertible ARM is an adjustable-rate mortgage that gives the borrower the option to convert to a fixed-rate mortgage after a specified period of time. These mortgages normally come with stipulations, and if a borrower decides to transfer from an ARM to a fixed-rate mortgage, the financial institution will usually impose a fee.
Convertible ARMs have the problem of requiring the borrower to keep track of interest rates and forecast future changes, something even experts can’t do. If loan rates decline, borrowers will gain from the convertible ARM. If interest rates rise, however, the benefit of a convertible arm is gone.
Last Updated on 05/25/2022 by Mark Verhoeven
Financial Consultant and Author