A convertible mortgage is a loan that begins as an adjustable rate mortgage and can be changed into a fixed rate mortgage at a certain point. The details depend on the terms of the loan. They can be useful for borrowers who expect interest rates to dip and ultimately rise again, but like all adjustable rate mortgages, they involve a bit of a gamble on where rates are headed in the future.
TL;DR (Too Long; Didn't Read)
A convertible mortgage is an adjustable rate mortgage that can be converted into a fixed rate mortgage. This type of mortgage can save you money if rates decrease.
Adjustable and Fixed Rate Mortgages
When you borrow money to buy property, you agree to pay back the initial amount, or principal, that you borrowed along with some interest. The interest included in each payment is a percentage, called the interest rate, of the amount of principal still owed on the loan.
You can usually either take out an adjustable rate mortgage or a fixed rate mortgage. As the name implies, a fixed rate mortgage has the same interest rate and usually the same monthly payments for the life of the loan. An adjustable rate mortgage, on the other hand, can have its interest rate fluctuate over time along with prevailing interest rates, causing your monthly payments to also go up and down. Exactly when and how frequently rates change depends on the details of the loan.
Adjustable rate mortgages typically start with lower rates than fixed rate ones that otherwise have the same terms. An adjustable rate mortgage is different from an interest only mortgage, where you pay only interest and no principal during the initial phases of the loan. Those types of loans can also see payments rise when you begin paying back principal as well.
Convertible Mortgage Basics
A convertible mortgage is a sort of hybrid of the two, starting as an adjustable rate mortgage but giving the opportunity for the property owner to change it into a fixed rate mortgage later on. It's useful for homebuyers who want the starting low rates of an adjustable rate mortgage but want the ability to lock in low interest rates later in the loan's life span. They usually have slightly higher rates than other adjustable rate loans.
Fixed Rate Pros and Cons
A fixed rate mortgage is often considered a conservative choice, since it enables you to know with certainty what payments you'll have to make over the life of the loan. Assuming your income doesn't drop and you don't get hit by other unexpected payments, you should know with reasonable certainty that you will be able to keep up with your mortgage payments.
Adjustable Rate Pros and Cons
With an adjustable rate loan, on the other hand, it's harder to predict what your future payments could be. Interest rates adjust due to many economic factors that are hard for even expert investors and trained economists to anticipate. If rates go down, you can end up saving money, but if they go up, you can end up paying more on your mortgage each month.
It's best to only choose an adjustable rate mortgage if you have a reasonable buffer in your income or savings between your current mortgage payment and possible higher future ones. Adjustable rate mortgages can also save you money, based on the initial lower rate, if you intend to pay them off quickly, before any possible interest rate changes.
Convertible Mortgages Pros and Cons
A convertible mortgage can be a good compromise, letting you get started at rates lower than a fixed rate loan with the ability to lock in a good rate if prevailing rates drop or stay low. They became popular during the 1980s, when interest rates were high and homeowners and lenders expected they would ultimately drop.
In the best case, interest rates will drop and you will be able to convert the mortgage to fixed rate loan at that low rate. Then, even if rates rise in the future, you will be locked in at the lower rate.
If interest rates instead start to rise, it will be more of a gamble whether to convert to a fixed rate loan and lock in a rate before rates get even higher or allow the rate to continue to fluctuate. You may want to consult with a financial planner or other expert on the best course of action.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.