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.