Conversion Option (Mortgages) – Definition

Cite this article as:"Conversion Option (Mortgages) – Definition," in The Business Professor, updated December 4, 2019, last accessed May 26, 2020, https://thebusinessprofessor.com/lesson/conversion-option-mortgages-definition/.

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Conversion Option (Mortgage) Definition

Conversion option refers to a clause that has to do with adjustable-rate mortgages (ARM) that enable an individual to change the adjustable-rate mortgage to fixed rates at a certain future date. Mortgage loans that have conversion options come at a cost, as its rates are typically higher than those without a conversion option. The conversion option also applies to preferred stock and bond issues. It allows its holder to change the shares into common stock.

A Little More on What is a Conversion Option

To be able to analyze the conversion option’s economics, borrowers need to add up the overall conversion option’s cost, including the actual cost of conversion to a fixed rate. They should then compare the total to the refinancing costs and convert into a fixed interest rate at a date in the future.

Why a Conversion Option  has Higher Fees

To convert to the fixed-rate, you first have to pay a fee. Also, the ARM conversion from the fixed rate is based on the market rate and at a given percentage at conversion time. If the estimation of the future refinancing costs happens to be less than the overall conversion option’s costs, then the conversion option is uneconomical. In this case, it will be prudent for the borrower to use a traditional adjustable-rate mortgage to make a fixed interest rate refinancing at a future date.

Insurance Industry vs. Conversion Option

The conversion option is also used in the insurance industry. A good example is health insurance. There is a clause that gives room for a policyholder to make changes to his or her insurance policy.

For instance, he or she can drop his or her term life policy and take a whole life policy instead. The policyholder can also change his or her critical care coverage to long-term care from a standard one. Note that this option is costly, meaning that the policyholder will have to pay additional costs in the process.

Also, when you want to request for conversion of your policy, there is usually a window period that applies to this process. To guarantee coverage passed the originally singed term policy’s limit, a policyholder may decide to do a conversion.

Note that it is not a requirement for the policyholder to undergo a medical examination to prove that he or she is in sound health. An alternative for a whole life policy could be a term life insurance that has a conversion option clause. However, this choice may require a policyholder to pay higher premium rates than what he or she would pay for whole life insurance.

Another thing that may necessitate a conversion is when a person is under group insurance coverage through an employer. Conversion comes in when this individual leaves employment and wants to change the policy to an individual life insurance policy.

What are the Benefits of a Whole Life Policy Conversion Option?

  • Your coverage does not automatically end as you grow old
  • You are allowed to give your health ratings, and still get the policy even if you are already sick
  • The policyholder stands to benefit from the broad investment benefits. Note that most policies consist of saving elements meaning that they are capable of building up the value
  • The death benefit from an insurance policy does not undergo taxation (it is tax-free). It, therefore, helps the policyholder to pay taxes on his or her estate if he or she leaves a significant amount to the heirs

Drawbacks of Whole Life Policy Conversion Option

One major drawback in the option is the cost of a policyholder incurs. Note that there are additional costs involved when a policyholder decides to convert.

Also, the conversion may include too much term coverage. Note that while a policyholder is young, the term policies held to cover a number of expenses like mortgage and the cost of educating children.

However, as the policyholder ages, he or she will need a reduction in the mortgage and now start building up some savings and help the children to become independent.  When it comes to this point, the policyholder will require less insurance, meaning that he or she will have to make changes again. The policyholder can always approach his or her insurance to see if it is possible to acquire a partial conversion.

Key Takeaways

  • Conversion option refers to a clause that has to do with adjustable-rate mortgages (ARM) that enable an individual to change the adjustable-rate mortgage to fixed rates at a certain future date
  • The ARM conversion from the fixed rate is based on the market rate and at a given percentage at conversion time
  • It is not a requirement for the policyholder to undergo a medical examination to prove that he or she is in sound health when converting to a whole life insurance
  • The process of conversion is usually costly, meaning that you will have to pay additional costs.

Reference for “Conversion Option”

https://www.investopedia.com/terms/c/conversion_option.asp

https://financial-dictionary.thefreedictionary.com/Conversion+Option

www.investorwords.com/1101/conversion_option.html

https://www.lendingtree.com/glossary/conversion-option/

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