Convertible ARM

  

Cars don’t have limbs. Unless they're Transformers. But a convertible ARM has nothing to do with Michael Bay and his fascination with things that blow up.

A convertible ARM is a type of mortgage product that allows a person borrowing money to convert his adjustable mortgage rate to a fixed interest rate.

ARMs are billed as a way to take advantage of low interest rates, as most variable teaser rates typically fall below fixed-rate options. However, as variable rates rise, they can surpass the initial fixed rates offered at the time of the signing. The positive feature of a fixed-rate is that payments never change on the amortization table.

Typically, the borrower gets a teaser rate on a 30-year mortgage. These teaser rates usually last for just a year or two, after which time the borrower then converts to a fixed rate...usually pre-determined as, say, LIBOR plus 250 basis points, or something like that.

Naturally, this is a difficult product to manage. It requires ordinary home buyers to speculate on future interest rate increases. If they choose to convert to a fixed rate, and the variable rate falls, they’ll end up paying more in interest. But if they don’t convert and rates rise rapidly, they will end up paying way more on their mortgage than they might have expected.

And then they'll be tempted to blow up their house for the insurance money, Michael Bay-style.

Related or Semi-related Video

Finance: What is Convertible Debt?43 Views

00:00

finance a la shmoop. what is convertible debt? okay so we presume you

00:06

know what debt is. if not go uh you know watch that video. we'll wait actually no [man smiles at camera]

00:12

we won't wait. so convertible debt is just normal debt

00:15

but with one potentially highly valuable added feature. its convertible into

00:21

something else. well we were Marvel superheroes that would be our superpower.

00:26

you know finance man or something like that.

00:32

anyway example time. drone Ranger Inc needs money to upgrade a factory so that

00:37

it can produce drones that don't just fly, they swim too. like Aquaman. Alright well

00:43

prevailing interest rates for its level of risk and credit worthiness are 7%. the

00:49

company needs to raise a hundred million bucks, and the idea of paying seven [graph shown]

00:53

million dollars a year for that debt is just too high a price, so the CEO boss

00:57

says no .no new factory for you but if the company could get the debt cheaper

01:03

well then she might run bulk. unfortunately the company's stock trades

01:09

today at a very low multiple of earnings. only 15 times the dollar share they'll

01:14

earn this year. so I don't want to raise the hundred million dollars by selling

01:17

equity. it would be dilutive to do so, meaning that they would have to print

01:23

too many shares to raise that hundred million dollars, specifically a hundred [Dilution defined]

01:27

million divided by 15 or six and a half-ish million shares. well some of the

01:31

company's investors or rather all of them believe that the company's stock is

01:35

and or will be worth more per share than it is today at some point in the future.

01:40

otherwise they wouldn't own the stock today, right?

01:43

so the wily CFO of the company wonders if there's a Miley Cyrus style best of

01:49

both worlds solution here where you could sell equity at a higher price in

01:54

the future in part for a price decline on the cost of renting the debt. and in [Cyrus shown swinging across screen]

02:00

fact there is and yeah you guessed that it's called a convertible bond, or

02:03

convertible debt. yeah different kind of conversion there.

02:07

all right well the drone rangers stock is 15 bucks a share today but through

02:11

careful negotiated back-and-forth with capital markets people at an investment

02:15

bank, the company learns that there actually is demand for its debt price to

02:19

pay only 3% interest. if that debt is convertible into equity at 30 bucks a

02:25

share. so what does that mean? well if the stock stays under 30 bucks so pretty [definitions on screen]

02:29

much forever, then the buyers of the debt or the lenders of the money to the

02:33

company got taken. that is they only got three percent interest on their money

02:37

when they should have gotten seven percent for loaning money as debt to the

02:41

company. but if the stock takes off and the over water underwater drones really

02:47

you know fly off the shelves, then the convertibility feature of the

02:51

debt will be exercised or used which would be a good thing. so the debt is

02:57

convertible at 30 bucks a share which means that a hundred million dollars

03:01

raised would cause the company to be diluted a hundred billion divided by 30

03:06

bucks, or you know 3.3 ish million shares, I eat it's half the dilution it would [equations]

03:13

have been at the company just sold shares at 15 bucks each.

03:17

it essentially wrote a call option to the buyers of the debt to be able to

03:21

call or buy its stock for 30 bucks a share or 30 times the current year's

03:26

earnings at some point you know whenever in the future. like being diluted at 30

03:31

times earnings is way less painful than being diluted at 15 times.

03:35

so yeah that's convertible debt in a nutshell. not what you find yourself in

03:40

during your midlife crisis when you desperately feel the urge to buy a [woman races by in sports car]

03:43

silver Beamer that cost three times our annual salary yeah. been there it was a

03:48

nice Beamer

Up Next

Finance: What is Busted Convertible?
14 Views

What is a Busted Convertible? A busted convertible is a convertible bond that will never be converted to stock because the underlying stock price i...

Finance: What are Convertible Bonds?
9 Views

What are Convertible Bonds? Convertible bonds are bonds that have a provision to be converted into equity common shares at a predetermined strike p...

Finance: What are the components of a mortgage payment?
1 Views

What are the components of a mortgage payment? Mortgage payments generally consist of (4) components acronymed as PITI: Principal, Interest, Taxes,...

Find other enlightening terms in Shmoop Finance Genius Bar(f)