18 April 2006

The lock period is the period during which the lender guarantees the rate and points. If an FRM is locked at 5.50% and 1 point for 30-days, for example, the lender is committed to make the loan at that price anytime within the following 30 days. Locks for longer periods are priced a little higher. Expect to pay another 1/8 point for each additional 15 days.

If the loan has not closed by the end of the lock period, it expires; the lender is no longer committed. If prices have not increased during the period, the lender will usually be willing to extend the lock for a small additional fee. If prices have increased, however, any lock extension will be at the new higher prices. This is a risk you want to avoid.

On a home purchase, select a period long enough to include the expected closing date, plus a safety buffer of 15 days. On a refinance, the required lock period depends on how long it takes the broker or lender to process your loan. You get that period from them, then add 15 days just in case.

If you barely qualify at today’s rates, lock as soon as possible. You are in no position to risk an increase in rates.

If you are comfortable with the risk, you can delay the lock in order to take advantage of the decline in price as the lock period shortens. For example, if market rates don’t change, a 45-day price of 5.5% at 1 point 15 days later should become a 30-day price of 5.5% at 7/8 of a point.

This assumes, however, that you receive an honest reading of the market price on the day you lock. You will if you are dealing with an internet lender who posts your price on the internet every day. You are also safe if you are dealing with an Upfront Mortgage Broker (UMB) who gives you the best wholesale price on the lock day.

In other cases, you may or may not get an accurate reading. The loan provider who knows you are in too deep to back out may up the price a bit, so the 1/8 point will go in his pocket rather than in yours. Indeed, he might discover that the market price went up instead of down. With no independent check, the “market price” is what the loan provider says it is.

You can’t prevent an avaricious loan provider from pulling that stunt with you on a purchase transaction because you have too much at stake and not enough time to start over. That’s why I recommend that you lock as soon as possible.

On a refinance with any lender other than your current lender, you can prevent it because you have a right to rescind the deal within three business days after closing.  The threat to do this will be sufficient to protect you against any kind of chicanery.

November 13, 2006

"I am an economist, puzzled by the phenomena of "locking". None of the markets I have studied have anything like it. Can you explain the economics of locking in one lesson?"

What It Means to "Lock" a Mortgage

When lenders "lock", they commit to lend at a specified interest rate and points, provided the loan is closed within a specified "lock period". (Points are an upfront charge expressed as a percent of the loan amount). For example, a lender agrees to lock a 30-year fixed-rate mortgage of $200,000 at 7.5% and 1 point for 30 days. A lock is contingent on the borrower meeting the lender’s underwriting requirements for the loan.

Why Locking is Needed

The need for locking arises out of two special features of the home loan market: volatility and process delays. Volatility means that rates and points are reset each day, and sometimes within the day. Process delays refer to the lag between the time when the terms of the loan are negotiated, and the time when the loan is closed and funds disbursed.

If prices are stable, locking isn’t needed even if there are process delays. If there are no process delays, locking isn’t needed even if prices are volatile. It is the combination of volatility and process delays that creates the need for locking.

For example, Smith is shopping for a loan on June 5 for a house purchase scheduled to close July 15. Smith is comfortable with the rates and points quoted on June 5, but a rate increase of 1/2% within the following 40 days could make the house unaffordable, and Smith doesn’t want to take that risk. Smith wants a lock, and lenders competing for Smith’s loan will offer it.

Why It Costs Lenders to Lock

If locks were equally binding on lender and borrower, locks would not cost the borrower anything. While lenders would lose when interest rates rose during the lock period, they would profit when interest rates fell. Over a large number of customers they would break even.

In reality, however, borrowers are not as committed as lenders. The number of deals that don’t close, known as "fallout", increases during periods of falling rates, when borrowers find they can do better by starting the process anew with another lender. Fallout declines during periods of rising rates.

This means that locking imposes a cost on lenders, which they in turn pass on to borrowers. The cost is included in the points quoted to borrowers, which are higher for longer lock periods. The lender who quoted 7.5% and 1 point for a 30-day lock, for example, might charge 1.125-1.25 points for a 60-day lock.

Controlling Lock Costs

Years ago, lenders controlled lock costs by requiring borrowers to pay a commitment fee in cash. The fee was returned to them at closing but forfeited if they walked from the deal. But today, commitment fees have mostly died out. Borrowers don’t like them, and lenders and mortgage brokers don’t want to place themselves at a disadvantage in competing for customers.

To control lock costs today, many lenders refuse to lock until borrowers demonstrate commitment to the deal by completing one or more critical steps in the lending process. For example, one lender recently explained its lock policy to its mortgage brokers as follows:

Our loans are well priced, but we only commit to you when you commit to us. To lock, you must submit the completed lock form, application (original, no copies allowed), credit report, appraisal, and either a purchase agreement or escrow instructions.

The logic of this lender’s policy is that its procedural requirements reduce fallout costs, allowing it to offer lower prices. Lenders who make it easy to lock have large fallout costs because some shoppers will lock with them as protection against a rate increase while they continue to shop for a better deal elsewhere.

Implications For Borrower Shopping

While the best (honest) quote is likely to be from a lender who requires extensive documentation to lock, these requirements impede effective shopping. For example, if the shopper identifies the lender offering the best deal but it takes 3 days to lock with that lender, the shopper is in limbo for 3 days. He has to hope that market rates don’t increase during the period, and if they do that the lender doesn’t pad the increase.

A mortgage shopper thus needs to know what each lender requires to lock, and how quickly the process can be completed if the shopper does her part. A good mortgage broker can help enormously. Brokers know lender lock requirements, can help expedite the process, and will keep the lender honest if the market changes during the lock process.