Conversion Option on an Adjustable Rate Mortgage

January 24, 2000 "I have been offered a 5/1 ARM with the rate fixed for the first five years at 6.875 percent. It then adjusts with the Treasury 1-year Constant Maturity index, plus 2.75 percent. After five years, I can convert the loan to a fixed rate mortgage (FRM) at a rate equal to the prevailing Fannie Mae rate, plus one percentage point. Does this conversion option have any real value for me?" The easiest way to assess a conversion option is to ask whether you would exercise the option after 5 years, assuming nothing else changed between now and then. Here are your possibilities, based on today's market conditions. Keep your ARM. The value of your index is 5.90 percent. The margin is 2.75. If you keep your ARM, your rate rises to 8.65 percent. Exercise your option and convert to a FRM. Fannie Mae's rate for your conversion option is 8 percent. Add the 1 percent margin and your new rate would be 9 percent. Refinance with an FRM. A zero-point FRM is available today at a rate nearer 8 percent than 9 percent. After settlement costs, the loan is still cheaper than a 9 percent FRM without settlement costs. Refinance into another ARM. A point-free, 5/1 ARM at 7.75 percent is available --.90 percent cheaper than your existing ARM. The difference more than compensates for any refinancing and settlement costs. If you do nothing, your ARM rate would rise to 8.65. To improve your situation, the best action would be to refinance into an FRM or an ARM. You would not exercise the conversion option because it is inferior to the refinancing options. This doesn't mean that the option has no value. Market conditions do change and it is possible that the option could have value in 5 years. But I wouldn't give up anything of value for it. Copyright Jack Guttentag 2002

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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