Edgar and Rebecca Wise had a 9 1/4 percent interest rate on a 30-year fixed-rate mortgage when they were living in Tampa, Fla. Now, after finding a place to live in the Washington area, they want more flexibility. Like many of today's home buyers, they chose a convertible adjustable-rate mortgage.
The Wises, who are scheduled to go to settlement in early December, have agreed to a 7 7/8 percent interest rate on a $125,000 mortgage from Perpetual Savings Bank that can only rise 2 percent during any year and a total of 6 percent over the life of the loan (features common for adjustable-rate mortgages). But with the additional convertible feature, the Wises have the option to switch to a fixed-rate mortgage after the third year at then prevailing rates by paying a $750 fee.
"We found it very attractive," Edgar Wise said. "With the 6 percent cap, we don't feel too threatened that rates will get too high."
But as more lenders offer convertible adjustable-rate mortgages, variations on the conversion theme are arising that might confuse or mislead borrowers. Knowing the fees and when the mortgage can be converted to a fixed rate are a few of the key questions that may help borrowers determine if they would benefit from a convertible adjustable-rate mortgage. Some lenders warn borrowers to make sure they're getting what they expect. Borrowers also take the chance of converting to a fixed-rate mortgage when the adjustable-rate mortgage might continue to fall.
"When someone says he has a convertible loan, they have to make sure that's what they're getting," said Judith Naiman, director of product strategies for the Federal Home Loan Mortgage Corp. (Freddie Mac). "They better make sure that the option they're buying is worth it."
Convertible mortgages aren't a new concept. Some lenders have allowed borrowers to convert mortgages on the anniversary date of the loan during the third, fourth or fifth year of the loan to whatever the fixed rate is at the time. Most of the convertible mortgages introduced this year allow the conversion much sooner.
What has made adjustable-rate mortgages attractive is that interest rates on fixed-rate mortgages generally have been rising, creating a spread between the interest rates of the adjustable- and fixed-rate mortgages. Currently, 30-year, fixed-rate mortgages are still at least 3 percentage points higher than 1-year adjustable-rate mortgages, which typically are at about 7 1/2 percent.
But even though there are similarities among convertible adjustable-rate mortgages, the differences might make one lender's mortgage more suitable than another's.
While most lenders charge the borrower from 1 to 4 points, with each point costing the borrower 1 percent of the loan amount, some lenders also charge 1/2 to 1 percentage point more on the initial interest rate of the convertible mortgage, compared with a traditional adjustable-rate loan.
Lenders also are varying the time a borrower can convert the loan to a fixed rate.
The standard period, such as for mortgages offered by Investors Home Mortgage and CitiCorp Savings, allows the borrower to convert to a fixed rate every six months between the 13th and 60th month of the loan. But some of the variations include converting anytime from the point of origination to the third year; from origination to the fifth year; or in a few cases from origination through the life of the loan.
When a borrower is ready to convert, he or she should find out the fixed rate. Under some programs, the rate is the one posted on the first day of the month; other programs set the rate at the time the paper work is processed. The borrower also should find out in advance what the conversion fee will be.
On average, lenders in the area are charging between $250 and $750. The Federal National Mortgage Association (Fannie Mae), which buys mortgages from primary lenders on the secondary market, recently dropped its 1 percent fee on the original principal when a borrower is converting the loan; other lenders said they are considering the same thing. Some lenders require a reverification of a borrower's credit history at the time of conversion.
Warren Lasko, executive vice president of the Mortgage Bankers Association of America, said lenders are making up for the small conversion fee by charging borrowers the slightly higher interest rates. "It's a wash for the consumer," he said. "He's paying for the option to convert."
John Reilly, assistant treasurer of Citicorp Savings in Washington, said convertible adjustable-rate mortgages are good for most home buyers, but that buyers must consider how much their monthly payments will be in the long term.
"We don't want to be in a position where a borrower can't make his payment," he said. "If at the time of conversion a person has a 9 percent mortgage and elects to take a fixed rate at 11 percent, we want them to fully understand what it means to their day-to-day finances."