Note Buyers USA

All that glitters is not gold

In their early years, ARMs were selected by marginal borrowers when interest on fixed-rate loans started climbing. “Well,” the loan rep tells the disappointed homebuyer, “I can’t get you qualified at 9.5 percent for that 30-year fixed-rate loan, but here’s what we can do. We can qualify you at 8.0 percent for the ARM. And what’s great is that when interest rates come back down, you can convert this ARM into a fixed-rate 30-year loan.”

At What Cost and Rate?
Have you found that elusive free lunch? Probably not. On occasion, the convertible option pays off. More often, its chrome dazzles more than its horsepower. Few borrowers ever exercise their option to convert. Here’s why:

- Higher interest rate. Most borrowers think they can convert at the market rate. Not true. If, for example, at the time of the conversion, fixed-rates have dropped to 7 percent, your converted fixed-rate would probably carry an interest rate premium of .25 to 1.0 percent— or a total rate of somewhere between 7.25 and 8.0 percent.
- Conversion fee. Lenders will charge a conversion fee that may range from a low of $100 to as high as 1 percent of the outstanding balance on your loan.
- Up-front cost. You also typically pay for the conversion privilege at the time you take out the ARM—chiefly through a higher starting interest rate or higher loan origination fees.

When Can You Exercise the Convertible Option?

Anytime you want to? Not necessarily. Most frequently, the option to convert lasts only between the thirteenth and sixtieth months (fifth year) of a 360-month (30-year) loan. Some conversion options terminate earlier than 60 months. While many ARMs do permit you to convert anytime within that four-year window of opportunity, others limit the conversion to the annual anniversary dates of the loan. If interest rates hit rock bottom in June and your anniversary dates in November, you could end up out of luck. To comply with the lender’s conversion rules, you will need to provide timely notice as spelled out in the loan agreement. If a loan rep offers a conversion option completely without charge, take it. But if this feature requires an up-front cost, or if the option stands critical to your decision to accept an ARM, stay focused on the substance. Remember, that flashy convertible that you’re admiring could prove to be a clunker.