How to Refinance an ARM (Adjustable Rate Mortgage)

With all the ballyhoo about adjustable rate mortgages (ARMs) in the media over the last six months, most people aren’t aware of a special feature in almost all ARMs. That feature is the conversion clause.

This clause presents the easiest and quickest way for a homeowner to refinance out of their adjustable rate mortgage without having to shop for a fixed rate loan. As a contractual provision in the mortgage, it is legally binding on all parties.

The conversion clause generally says the borrower must wait a period certain, say one year, before they can trigger the conversion feature. This clause also provides the fee amount, if any, associated with the conversion and states what fixed rate the homeowner will receive once converted.

The clause may read something like, “At the end of the full first mortgage year, the borrower may convert to a fixed rate equal to the prime rate plus one for a fee of $500.”

If the prime rate is 5%, the borrower would receive a fixed interest rate of 6% (5 + 1) for the remainder of the mortgage term. Keep in mind that not all fees are at a fixed rate.

Some are equal to the monthly interest the borrower would have paid in the month of conversion had the borrower not converted. Some are an average of the last three months interest paid by the borrower.

Regardless of the clause’s wording and how the fee, if any, is computed, it behooves the borrower to read his mortgage contract. The conversion clause should have been explained at the time of application and at close of escrow. Many contracts will have this feature as a rider to the contract so that it is very apparent to the borrower.

If you have an ARM that does not contain the conversion feature, your best bet is to contact your mortgage company and ask if they will entertain you switching into a fixed rate contract. Given the current scenario, you may be pleasantly surprised at the answer.

Remember, your smartest first step is to speak with your current mortgage holder as they are the ones who control your mortgage. You gave them that control when you signed the paperwork.

Hopefully that doesn’t sound totally negative since they can, by law, agree to alter the contract per your request. When you ask them to be allowed to switch to a fixed rate contract you are, in essence, making them a brand new offer.

The truth is you can ask your mortgage company to alter the contract in anyway that will benefit you. For example, asking for the interest rate to be tied to a less volatile index, reducing the margin rate, paying interest only for a period of time are other ways to reduce the burden of an adjustable rate.
If the mortgage holder agrees, you have switched from a volatile ARM into an ARM that mirrors a fixed rate mortgage price wise. Of course, if your home has held its value and you have the ability to bear the costs of applying for a fixed rate mortgage, then you may wish to pursue that avenue.

Above all, don’t panic. Keep your head and review all of your options. There is one that fits your situation and pocket book.