Many of this summer's new home buyers are getting into convertibles--convertible mortgages , that is.
A convertible mortgage starts out as an adjustable-rate loan with a low interest rate. Today, many California lenders are offering the loans with an initial interest rate below 8%, compared to an average 10 1/2% on fixed-rate loans.
Like other adjustable-rate loans, the interest rate on convertibles changes periodically, usually every six or 12 months. However, the borrower has an option to convert the loan into a fixed-rate mortgage during a specified period--usually between the end of the first year and the start of the sixth year of the repayment term.
Convertible loans are attractive for several reasons. Their low initial rate makes it easier for the borrower to qualify for a loan because beginning monthly payments are small.
If interest rates head lower, the borrower can keep the rate adjustable, and the mortgage payment will drop. But if rates head back up, the homeowner can convert into a fixed-rate mortgage to "lock in" his monthly payments and avoid future increases.
Convertibles have been around for several years, but they've taken on new luster because rates on fixed-rate loans have risen about 1 1/2 points since March. Many of the people who wanted fixed-rate loans can no longer qualify for them, so they're opting for a lower-rate convertible and hope to change into a fixed-rate loan later.
Convertible mortgages have also become easier to get since the Federal National Mortgage Assn.--a key provider of mortgage money--recently made some technical changes that encourage more lenders to make the loans.
Cites More Control
"The bottom line to convertibles is that they give you a lot more control over your mortgage," said Rick McGill of Great American First Savings Bank, a San Diego-based lender that began offering convertibles last week. "You can keep the rate adjustable as interest rates move down, and then switch it to a fixed-rate when rates go back up."
But while convertibles offer several advantages, they also have some drawbacks.
First, converting isn't free. Most lenders charge the borrower 1% of the remaining loan balance for the privilege, and many tack on a processing fee of up to $250. In addition, the interest rate on the converted loan is often about one-quarter of a point higher than the fixed rate the homeowner could get if he got a brand-new mortgage.
Since the loan can only be converted once, borrowers who change into a fixed-rate loan because they think rates have bottomed out will be sorry if rates move even lower. And once it has been converted, most lenders will not allow the loan to be assumed by a new buyer--a change that could make the property more difficult to sell when rates are high.
Less Than Refinancing
Although banker McGill admits that converting can be costly, he's quick to point out that it usually requires less up-front cash than it would to refinance with a new fixed-rate loan.
A homeowner with a $100,000 non-convertible ARM could pay as much as $3,400 in points and various fees to refinance into a new, fixed-rate mortgage, McGill says. By comparison, a borrower with a convertible ARM would only have to pay about $1,000, in part because the conversion process doesn't require a new title-insurance policy, lengthy escrow and the like.
Some experts also dispute the notion that borrowers need to accurately predict which way rates will go in order to benefit by converting from an adjustable rate to a fixed rate.
"Not everyone will convert when interest rates hit the bottom of the cycle, but everyone can convert at a rate they find acceptable," says Shirley Parish, an executive with the Federal National Mortgage Assn. in Washington.
"If you're happy that you were able to convert to, say, a 10% fixed rate, you shouldn't be too upset if fixed rates head a little lower," Parish adds. "Converting involves the exact same544369011when you choose between an adjustable-rate mortgage and a fixed-rate loan."
Borrowers searching for a convertible loan should follow the same guidelines used to evaluate standard adjustable-rate mortgages, Parish said.
That means the loan should have a "cap" that prevents the lender from adjusting the loan upward more than two percentage points a year, and another cap that prevents the interest rate from rising more than five or six percentage points over the life of the loan.
Borrowers should also find out which index the lender will use to make the periodic adjustments while the loan is still adjustable. People who think rates are heading downward are usually better off choosing an ARM linked to the one-year Treasury bill index because it reacts to changes in interest rates quickly.
More cautious buyers should opt for a loan linked to the slower-moving cost-of-funds index published by the Federal Home Loan Bank Board.
Borrowers must also examine how many points the lender will tack on to the index rate to provide it with a profit. A margin, or "spread," of two to 2 1/2 points is typical.
"The keys to picking the right loan is to study all your options, shop for the best deal and know exactly what your're getting," says Parish at Fannie Mae. Borrowers who pick a convertible mortgage without doing their homework could well wind up with a lemon of a loan.