Every consumer dreads shopping for a mortgage. Not only is the consumer afraid of paying a rate which is too high, they are uneasy regarding the right program for their situation. To make matters worse, they are totally confused about the rules of the mortgage interest rate “game.” For example, when asking a lender about their rates, the lender is likely to respond with a question: “Are you going to lock the rate or float?

Many consumers do not even know what these terms mean, let alone how they may apply to their particular home purchase or refinance situation. It is important to understand the meaning of the terms before we can more fully appreciate the nuances of the rate game–

• To lock a loan means that the lender will guarantee a rate for a certain period of time. For example, if you complete a mortgage application on June 1, the lender might lock the loan in at 5.0% and guarantee that rate as long as you close before the last day of July.
• To float a loan would be to complete an application without the lender guaranteeing any particular rate. You basically complete loan application with the idea that you will lock a rate sometime before settlement.

It is quite obvious that locking a loan or floating a loan involves risk. The risk is that rates will move in the future—during the period between loan application and settlement. If the applicant floats the loan, there is a risk that rates will move up before the purchase or refinance transaction is closed.  If the applicant locks the loan, there is a risk that rates might move down.  For a lender there is a very similar risk—if the loan is locked and rates go up in the future, the lender is subject to losing money.

Because the risk involves the movement of interest rates sometime in the future, the lender must find a way to mitigate these risks—otherwise consumers would not be offered the opportunity of rate protection through locks.  The lender does this by participating in a futures market.

The futures market enables a participant to sell a commodity sometime in the future. In this case, the commodity is a mortgage loan with particular characteristics (such as a conventional 30 year fixed) and a particular interest rate. It is no different than a farmer selling corn at the beginning of the planting season to mitigate the risk of the corn falling to prices which are below the costs  incurred to produce the corn. When the lender sells the mortgage in the futures market, that lender is guaranteeing delivery of the loan at a certain interest rate. Within the secondary markets that exist for mortgage loans, larger lenders pool many loans together to form mortgage securities.

The risk for the lender does not end with the selling of the mortgage loan in the future. What if the loan does not close? This could happen for several reasons, including a purchase agreement falling through or the loan not being approved. The lender has agreed to deliver a loan, and now the lender can’t. In a perfect world, the lender would now be liable for purchasing a similar loan and delivering it. If rates had moved down, it will cost that lender more money to purchase a replacement mortgage because the commodity is now more valuable. In reality, the lender guarantees delivery of a certain amount of mortgages that includes a pre-calculated amount of fall-out. The real risk involves major interest rate moves which would cause more or less fallout than originally predicted.

What does this mean to the consumer?  For one thing,  because locking in a loan involves risk to the lender, the consumer may be charged a fee up-front to lock the mortgage. The fee paid up-front may or not be applicable to the closing costs quoted. It is more common to pay lock-in fees for longer term locks (a 90 day is more likely to require a fee than a 15 day lock).

In addition, because locking a mortgage loan involves futures risk, the longer the lock period, the higher the rate quote.  For example, if a consumer would like to lock a loan in for 30 days, the quote may be 7.0%.  For 90 days, the quote may be 7.125%.  The shorter the lock period, the lower the risk to the lender.  Of course, consumers purchasing new homes are in need of the longest lock periods because of the longer delivery times associated with new homes.

The ultimate protection for the consumer?  This involves a lender offering a locked rate that will move down if rates move down before closing. The lender offering this option would have to purchase an optional delivery in the futures market which is more expensive and this cost is likely to be passed on to the consumer. Cap protection?

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