Adjustable mortgages that can shift to fixed rates gain appeal

Anyone thinking about buying a home these days faces an uncomfortable choice of mortgages: Should he take the security of a fixed-rate mortgage, even though the interest rate has been going up and now tops 11 percent, with prospects for more increases to come before the deal can be closed? Or should he take an adjustable-rate mortgage (ARM), where the rate might be three percentage points lower but there's the uncertainty of higher payments in the future if overall rates go up?

For some, the answer is a bit of both: convertible mortgages. Lenders refer to them as convertible ARMs, and they start out like a one-year adjustable, but can be converted to a fixed-rate loan during a specified time period. In most cases, that time period starts shortly after the first year of the loan and goes until the end of the fifth year.

Two recent changes in the convertible ARM, one coming earlier this week, should make these loans even more attractive.

Until this summer, the convertible ARM wasn't used much, because the Federal National Mortgage Association, or Fannie Mae, which buys many of these loans from banks and other lenders, would buy only convertibles that were changed on the anniversary date of the mortgage. But as of June, a convertible ARM can be switched to a fixed-rate mortgage anytime between the 13th and 60th month.

This way, homeowners don't have to hope that the best interest rate environment coincides with the date they're able to convert. If they're in an ARM at 8 percent, for example, and fixed rates slide to under 10 percent, they can move to the fixed rate. Even though the monthly payments would be higher, the homeowner would know that, except for taxes and insurance, those payments would not increase. The new loan can be either the 30-year mortgage, or the 15-year variety where the payments are higher but equity builds up faster.

``This change came at a very good time,'' says Fannie Mae spokeswoman Bonnie O'Dell. A few months after the June change, fixed-rate mortgages started climbing past 10 percent, while ARM rates stayed under 8 percent. Today, the difference, or ``spread,'' between the two rates is as much as three percentage points at some lenders.

On Monday, Fannie Mae announced another improvement in its convertible ARM program. Converting from an ARM to a fixed-rate mortgage has never been free, and it still isn't, but it's now considerably cheaper than before. Under the previous Fannie Mae program, and programs still used by some lenders, the ``conversion fee'' is 1 percent of the original mortgage, plus $250. On a $70,000 mortgage, that would have meant a total charge of $950.

This week's change by Fannie Mae eliminates the 1 percent charge. Now, any lenders who intend to sell their convertible ARMs to Fannie Mae won't be able to charge more than $250. ``We hope this will make our product more competitive and that we'll make it up [any lost revenue] in volume,'' Ms. O'Dell said. The change applies to new convertible ARMs as well as those that have already written, she said.

Some other lenders that don't sell their loans to Fannie Mae have already eliminated the 1 percent conversion fee, while others still charge it, or even a little more, perhaps 1 or 2 percent.

``Not all lenders have been charging the 1 percent conversion fee,'' says Greg Quick, assistant vice-president at Comerica Bank in Detroit. But many lenders, he says, have ``portfolio loans'' that are kept in their own portfolios and aren't sold to Fannie Mae or any other outside investor. These lenders simply charge $250 (more or less) for the paper work.

``We're presently reviewing our program,'' Mr. Quick said. ``We currently have the 1 percent conversion fee.''

With the 1 percent conversion fee in place, there may be times when it makes more sense to take an ordinary ARM, then refinance into a fixed-rate mortgage when rates fall enough, even though this procedure means reapplying for a new mortgage and paying all the fees and charges that go with it, including the appraisal, legal fees, application fees, and ``points,'' usually 2 or 3 percent of the new loan.

The reason for this is that ordinary ARMs are often about one-eighth to one-half of a percentage point cheaper than convertible ARMs. If you have a convertible ARM and you don't switch to a fixed-rate loan for two or three years, your higher payments over that time might offset the savings from lower conversion fees, says Richard Peach, senior economist at the Mortgage Bankers Association of America.

This week's elimination of the 1 percent conversion fee by Fannie Mae ``would significantly reduce the cost of the convertible option,'' Mr. Peach says. ``It would change the calculation quite a bit in favor of the convertible.''

Some lenders have created even more variations on the convertible ARM. Commercial Federal Savings in Omaha, Neb., for example, has a convertible ARM that can be switched to a fixed-rate mortgage and back to an ARM. And First Federal Savings Bank of America in Fall River, Mass., has extended the convertible option to three-year ARMs, where there are no adjustments for the first three years.

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