ARM Conversion Option: What It is, How It Works

What Is an ARM Conversion Option?

An ARM conversion option is a clause associated with some adjustable-rate mortgages (ARMs) that allows the borrower to convert the variable interest rate to a fixed rate within a certain time period or at certain future dates.

How ARM Conversion Options Work

An ARM with a conversion option is called a convertible ARM. Introduced in the early 1980s, convertible ARMs entered the scene during a period of double-digit fixed-rate mortgages. The theory was that because interest rates were historically unlikely to go much higher (barring extraordinary inflation), borrowers of convertible ARMs could essentially bet on the greater likelihood of lower rates in the future.

However, early convertible ARMs were quite expensive and contained onerous restrictions. And while they have grown more competitive, even today, the conversion option is not free. An ARM with a conversion option will typically have a higher ARM margin rate (and, therefore, a higher fully indexed interest rate) or higher costs than ARMs without a conversion option.

Pros and Cons of an ARM Conversion Option

Some might say that ARMs with conversion options offer the best of both interest-rate worlds: the chance to move with market rates but also to lock in a steady rate.

The main pro comes if an interest-rate decline is on the horizon. The convertible ARM offers a way to reap the benefits of falling interest rates and lock them in early in the life of the loan.

However, being able to convert the rate has its drawbacks since it forces the borrower to monitor interest rates and predict their path, something that even financial pros don’t always do reliably. Also, borrowers might have to move fast since the new fixed interest rate is determined based on the lowest rate within a week of your final decision to convert.

Also, opting for a lower interest rate may appear like a no-brainer, but the numbers don’t always add up, particularly since you must pay a conversion fee. The fixed rate to which the ARM is converted is typically based upon the general market interest rate at the time of conversion plus a certain percentage. If future refinancing costs are estimated to be less than the total costs of the conversion option, then the conversion option is not economical. The borrower would be better off with a traditional ARM with the intent to refinance into a fixed interest rate at a future date.

Also, the fixed rate that you receive after converting will usually be somewhat higher than the initial rate of the ARM, especially if you received a low teaser rate. To analyze the economics of a conversion option, borrowers should total up the cost of the convertible ARM (an initial higher interest rate and/or higher loan costs than with regular ARMs) plus the cost of the actual conversion to a fixed rate. Then, compare this sum to the costs of refinancing into a fixed interest rate at a future date.

When to Use an ARM Conversion

If a sharp interest-rate tumble seems imminent—if the Federal Reserve (Fed) seems likely to cut the federal funds rate, for example—then it might be a good time to convert your ARM. The Fed sets this rate eight times a year; if possible, you could wait a few months to see if a rate-cutting trend is underway. Naturally, you would want to lock in when interest rates are at their lowest.

You’ll also want to compare the general interest rate with your loan’s teaser rate—if you’re still in the latter—and with when your ARM’s interest rate will reset.

Along with interest rate trends, consider your personal situation and whether a fixed rate makes sense. If a borrower plans to be in the home for the short term, they may move before the interest rate reset, making it less beneficial to pay the cost to convert. However, if you think that you will remain in the residence for a while, the conversion might make sense.

Remember, borrowers are generally allowed to invoke their conversion option clause within the first five years of their mortgage, so make sure any moves coincide with the time frame. Before considering a convertible mortgage, be sure to research mortgage lenders to find someone who has experience with ARMs.

Special Considerations

Conversion options also exist in insurance policies. A conversion option, from the context of the insurance industry, can refer to a clause that allows the policyholder to change a term life insurance policy into a whole life policy. Exercising such an option in most cases will incur additional costs for the policyholder. Furthermore, there may be a specific window of time when such a conversion can be requested. A policyholder might choose to convert to guarantee coverage beyond the limits of the term policy for which they originally signed up.

Under a whole life policy, they might also not have to submit evidence that they are in sound health or agree to medical examinations. Having term life insurance with a conversion option clause can be an alternative to paying for a whole life policy from the start, which would include even higher premiums for the policyholder to pay.

A conversion could also be necessary if an individual was covered by group insurance through an employer and, after separating from the company, wants to switch the policy for which they have been paying to an individual life insurance policy.

Conversion options can also be found in health insurance—for example, with options for a policyholder to change their critical care coverage from a standard policy to one that specializes in long-term care at private facilities.

The Bottom Line

Some adjustable-rate mortgages contain an ARM conversion option, a feature introduced in the early 1980s. This clause allows the borrower to convert the variable interest rate to a fixed rate within a certain time period. This allows the borrower to take advantage of falling interest rates. The clause generally contains conditions and limitations. For example, lenders generally charge a fee to switch the ARM to a fixed-rate mortgage, as well as a larger ARM margin during the variable period.

When interest rates are low, ARMs with conversion options are less attractive. However, if inflation and a consequent rise in interest rates crop up, they can seem more appealing.