What is a loan conversion?On August 21, 2019 by Michael Richardson
If, like many others, you have been to a dinner party where the word loan conversion has been mentioned, here you can get a quick overview of what it is. Then, next time, you don’t just have to nod, but can actually talk a bit about loan conversions.
A loan restructuring covers the act of repaying your fixed-rate mortgage and taking out a new loan of the same type. The reason for doing so is because the interest rates and rates on loans are constantly changing. This means that loans can be borrowed at different interest rates at different times, as well as borrowing and repayment loans at different rates.
The idea of converting your loan thus lies in the fact that one can replace a loan with a level of interest and take out a new loan with another level of interest. You talk about levels of interest rates because you can either up or down your loan.
Down loan conversion
If you convert down, your interest payment will be reduced and the purpose is thus to reduce the total payment you pay on the loan. This type of loan conversion is called a down conversion because you take out a new loan that has a lower interest rate. What you should be aware of is that you increase the outstanding debt on the loan when you do this.
You do this because you have to pay fees and foundation costs on the new loan, as well as the fact that you take out the new loan at less than 100 – but you typically pay off the old loan at 100. Because you increase the amount you actually owe the lender , the new interest rate you get on the loan must be well below the interest rate you have on your current loan.
A rule of thumb is that the interest rate must be about 2 percentage points below before it can pay off to make a down conversion. However, it also depends on the size of the loan to be repaid. Another thing to be aware of is that your interest deduction will fall because you pay a lower interest rate on the new loan. This despite paying higher interest rates.
If, on the other hand, you make a conversion, you take out a loan with a higher interest rate. As the market interest rate rises, the bond rate falls on one’s loan. This means that if you take out a new loan with a higher interest rate but a lower interest rate, you can reduce the residual debt on the loan because you can repay the loan at a lower rate than you raised it. However, the benefit rises on the loan as you pay a higher interest payment.
An up-conversion is by nature more speculative than a down-conversion, because an up-conversion plans to down-convert later. The trick is to up-convert to reduce its debt, but down-convert when interest rates fall again. You can never know for sure how the interest rate will develop over time, and therefore there is a certain risk associated with an upward conversion. The interest rate has to fall again before the new higher yield eats the gains from the conversions.
In short, a down conversion is a conversion of loans to a lower interest rate with increased residual debt – whereas an upward conversion is a new loan with higher interest rates and lower residual debt. However, they typically convert down when interest rates fall again. Many banks have conversion monitoring on loans, so you as a borrower can be notified when it makes good sense to either make an up or down conversion.
These descriptions are to a lesser extent related to loan types such as consumer loans or quick loans.