How Do Rate Locks Work?
There is one thing in common among all of our clients. No matter what price point, no matter what loan size, no matter good credit or bad, no matter first-time buyer or seasoned investor, all are looking for the lowest interest rate at the lowest cost. But how does a mortgage borrower secure such terms? A part of the home loan process is "locking an interest rate" and this process could use a bit of explanation, so as to dispel some of the myths and offer a better understanding of how things work.
What Is a Rate Lock?
You've done your interest rate shopping and made a decision about working with a mortgage lender/broker. The time has come to "lock" a rate. What does this really imply? A rate lock is a commitment the lender makes to you to preserve a given rate for a specific period of time. In exchange for this commitment, you, the borrower, are insulated from market risk. Once your rate is locked, that is (barring a few exceptions) the rate you will obtain for the life of the loan. With many lenders today, there is no cost to lock a rate, but as you'll see below, there are implications once a lock is in place. It is fair to say a rate lock is a commitment on both sides of the transaction, borrower and lender.
Time Is of the Essence
All rate locks exist in finite periods of time and the most common lock periods are 30 days, 45 days and 60 days. Longer locks will commonly have higher rates or costs associated with them, and this is a function of risk. The longer a lender commits to preserve a rate, the more the lender is exposed to underlying financial market volatility. Think of your rate lock in the same light as a life insurance policy. Purchasing a policy with a longer term will be more expensive because the likelihood of a claim increases for the insurer as the years go by.
Breaking the Chains
So now that you've locked your rate, what happens if your lock expires, or you decide to break the lock, or rates go down? These are all valid questions and they can all be addressed by the blanket statement that just as in life in general, breaking a commitment in finance has consequences as well. Some lenders offer enticing "float down" policies and suggest that clients can have it both ways --- both locked and floating. There is always an offset with such approaches because behind the scenes in the mortgage secondary market, rates locks are complex hedges that involve costs and have metrics that impact a bank's efficiency and cost of providing funds. All lenders want to have strong "pull through" on locks, and their ability to offer future clients competitive rates depends on this. All this said, sometimes rates do drop dramatically while a borrower is in process and there is potential for a "renegotiation," but this is not common and any rate lock should always be perceived, first and foremost, as a "for better or worse" proposition. Finally, transactions that run longer than their lock periods are faced with extension costs, which are best avoided. Borrowers should know that they cannot deliberately exhaust a rate lock in the hopes of capturing a new, lower rate with the same lender. In those cases there is often a 30-day "freeze" where a new lock would be subject to "worst case" pricing.
Locking your interest rate on a mortgage is an important decision and an important commitment. A good lender can help you navigate the nuances of the choices before you. Fundamentally, one locks a rate to prevent the risk that rates will go higher while in the process of purchasing or refinancing a home. What we see, in practice, is that deliberate action tends to relieve stress and assure a better outcome. "Floating" a rate for better is always tempting because as we agree, everyone is enticed by the idea of lower rates and lower costs. But remember, temptation can lead to unncessary risk and risk is what a rate lock strives to address by tamping down market volatility and containing aspects of your process that you don't control. Understanding how a rate lock works and formulating your own plan on locking is a smart move, and we're here to help you with it.
Lock 'em and doc 'em,
Vice President of Mortgage Lending
Marin Office: 324 Sir Francis Drake Blvd., San Anselmo, CA 94960
Berkeley Office: 1400 Shattuck Ave., Suite 1, Berkeley, CA 94709
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