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 3.50% and guarantee that rate as long as you close before
the last day of May.
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 a loan involves
risk to the lender, the consumer may be charged a fee up-front to lock the
mortgage (we do not charge a lock fee). 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. For example, a 120 day lock for a new home is more likely to
require a fee than a 60 day lock for the purchase of an existing home.
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 3.75%. For 90 days, the quote
may be 4.00%. 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? Sounds like a topic for future discussion.
Mike Ervin
Senior Mortgage Banker
PH: 650-735-5261
CEL: 650-766-8500
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