Convertible Loans

You might have heard the word “convertible” in relation to few financial terms like bond, adjustable-rate mortgages (ARM), preferred stock. If you have a bond which is convertible, you can convert it into common equity (issuer’s shares) in future during the bond period and the conversion option will be implemented on your decision. Indirectly it means that you will gain the ownership in the company by the percentage value which would depend on the numbers of stocks you own. But then you should be more careful to be at more risky side as you would play in secondary stock market. Thus we can say that convertible bonds have a hidden stock option. Some of you may own preferred stocks of a company. By preferred stock, you might be aware that you would get regular dividend payments like interest payments in case of fixed bonds. If your preferred stocks are convertible then after a predetermined date, you would be able to convert them into a fixed number of common shares. Similar kind of situations is also present in case of loans.

You would guess that how loans can be convertible. But it is true nowadays. Basic concept behind it is that you can convert one type of loan to another if you wish. I have heard in case of structured finance and public finance. When we discuss structured finance, different types of loans trigger in our mind. These loans are asset-backed or mortgage-backed. Take an example of adjustable-rate mortgage (ARM). You might opt for ARM that too convertible. This would help you to lock in interest rate for certain period. You would ask why you would go for ARM. If the situation is not in your favor after a specified period and you perceive that interest rate might go up. In that tight position, you still desire to prefer stable payments then ARM would be beneficial as you can convert it into a fixed rate loan. The financial institution would charge a fee to switch the ARM to a fixed-rate mortgage. But don’t forget that fixed rate repayments would be little higher than current market rates. You can also choose to convert the ARM in vice-versa mode i.e. from fixed rate to adjustable.

We all know that there is lot of competition everywhere. That competition is seen in banking and finance industry where lenders compete to offer different loan products. They try to make each product more attractive and flexible for you. Convertible loans are the outcome of these processes. People find these loans very handy as the changing face of economy has created fear in peaceful mind of investors. I mean we can’t control interest rates but we can plan out in a way that we would not loose our peaceful mind.

You might have heard of Interest Only Loan. Don’t get confused with word “Interest”. You will also have to repay principal amount. If you not receive incomes regularly but in “lumps” then this type of loan might suit you. You can take it for a fixed period. Most of the time you can repay minimum interest amounts. When you receive fat income occasionally then you can pay off the principal amount also. There seems no conversion facility in this type of loan. But the lender gives you the flexibility of time space to pay off your loan’s principal. Similar to this type, there is another loan called Balloon Loan. In this type, you have the flexibility to give monthly repayments at very low fixed interest rate for a fixed period. At the end of the fixed period, you have to repay the outstanding loan amount. But keep in mind that the outstanding repayment should be made in one installment completely. I know what you are guessing. You could fail to repay the balance amount in full in the end. That much risk you have to plan out and be prepared for another loan option. In that case you can opt to get the new loan either from same lender or you can plan from somewhere else.

The lender offers you so much flexibility in loan terms and conditions. But if you are not careful then these greedy plans might force you to choose another loan to fulfill the commitment of first loan. You never know the economic condition in next few years hence it’s not fairly simple to opt any convertible loan. I mean the lender might charge you higher interest rate for second loan which you desperately need to cover old loan. Perhaps in that scenario, you might have no alternatives.

Many of you might have heard of loan for retirees. Yes, you are correct. It is called Reverse Mortgage Loan. If you fall in aged people category and have retired from professional life. If you have not much income to meet the daily expenses and poor in terms of cash on hand. Still you want to live a good life then reverse mortgage loan might help you. But there is one prerequisite which is mandatory to be eligible for this type of loan. You should be owner of some rich asset. I mean you should have a home having some worth. The bank is ready to provide you this type of loan but the loan amount will purely depend on what your house is worth. You can borrow a certain percentage of that worth amount. You don’t need to make any repayments in return. But please take care that you should avoid spending the loan fund too lavishly. Otherwise that will not prove to be a sensible retirement life. I mean you should not forget of those heirs who might expect something from you. If you plan to invest some part of that cash on hand, then you can successfully create an ongoing income also.

If we go by the definition of convertible loan, then you will gain knowledge of another section of flexible loan. When one company or lender lends loan to another company, then a special type of option is reserved with the lender. Through this option, lender can convert the outstanding loan into common or preferred stock of borrower company. The lender opts to exercise this option within a specified time frame and at specified conversion rate. The borrower company does regular cash repayments to the lender. But after some period, if the lender thinks that it is more profitable in owning the shares of borrower company as its share price might go up. Depending on the risk appetite, the lender decides either to choose preferred or common stocks. Now you would ask why would any lender offer such loan or why would any borrower company would be ready to accept it. Actually this type of loan benefits both the parties. In this type of convertible loan, the borrower gets some interest rates concession and can negotiate loan terms and conditions. Its cash position also becomes strong when the lender decides to opt to convert the debt into equity. On the other side the lender gets the ownership in the borrower’s corporation. The lender also gets more profit if the converted stock price rises in future.

In field of education loan also, convertible loans are gaining popularity. The sponsor gives the flexibility either to repay the loan amount after the completion of the study and appointment in any other company. This type of loan also offers another term and condition to work for sponsor company for agreed period of time. Through this option, the entire sponsorship is converted into almost full scholarship. These sponsorships are awarded based on academic results, co-curricular activities, family background as well as an assessment of student personality. Depending on the examination results, student become eligible for full sponsorship option and then the sponsor can absorb the student under specific terms and conditions.