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What is a Conversion Option?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 28 August 2016
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    Conjecture Corporation
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Conversion options are an example of a financial option that may be employed with various types of investments. Essentially, a conversion option makes it possible to switch from an existing applicable rate to a different one. The strategy of a conversion option can be employed with preferred stock, bond issues, and mortgages.

When it comes to bonds or preferred stock issues, the ability to invoke a conversion option is usually spelled out in the documents that outline the terms and conditions for the sale and acquisition of the securities involved. Depending on the exact structure of those terms, there may be specific conditions that must take place before a conversion can take place. The structure of the conversion option may also be based on a timetable, allowing the investor to only invoke the option after the securities have been held in ownership for a certain period of time.

When it comes to mortgages, a conversion option usually allows the homeowner to switch from a fixed to a variable rate of interest, or vice versa. As with the conversion option approach to stocks and bonds, there are normally certain criteria that must be met before a conversion option may be invoked. One common stipulation is that the homeowner may not be behind in mortgage payments.

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Choosing to enter any transaction where a conversion option is available should be approached with a careful analysis. This can involve considering the higher interest rates and the higher setup costs that are normally associated with any mortgage or purchase that offers this option. Depending on the circumstances of the individual and the projections of economic performance that are anticipated for the life of the transaction, going with a conversion option may or may not be a good move.

One point to ponder is that there is usually a fee that is invoked when a variable rate of interest is converted to a fixed rate. This additional expense should also be taken into consideration before committing to any contract involving a conversion option. If there is a strong suspicion that making use of the option would prove to be more expensive than refinancing a standard fixed mortgage, the borrower would probably do well to go with a fixed mortgage rate and forget about the conversion option altogether.

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