Why Is Locking Unique to Mortgages?
"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". 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. On the other hand, a deceitful broker can expose the borrower to additional hazards. See What Happened to My Mortgage Lock?
You Are Protected if You Use the Professor's Certified Lender Network
Lenders who are certified by the professor are committed to the following lock policies.
Lock Charges: Certified Network Lenders (CNLs) charge borrowers a maximum fee of $295 to process their loans, with the charge credited back to the borrower at closing. The lender can also collect an appraisal fee of $300-$800, depending on the type of property and its size, to cover the appraisal cost. None of this fee goes to the lender, and it is not refundable.
CNLs Upon Locking a Loan Must Provide a Lock Confirmation Statement That Includes the Following:
- Product Type
- ARM detail(margin, index value, adjustment caps, max/min rate)
- Loan amount
- Interest rate
- Other lender fees
- Mortgage insurance premium - upfront or monthly
- Lock expiration date
CNLs That Do Not Lock Immediately Must Adhere to the “Twin Brother Rule”: : That rule states that the price locked will be the price the lender would quote on the same day on the identical transaction to the borrower’s twin requesting a price quote. This rule implies that if the market price decreases before the price quoted to the borrower can be locked, the CNL will lock the lower price. If the market price increases before the price quoted to the borrower can be locked, the CNL will not lock until explicitly authorized to do so by the borrower.
CNLs That Over-ride a Price Lock Because a Property Appraisal Alters the Pricing Must Play it Both Ways: If the appraised value is higher by enough to lower the price, the borrower receives the benefit of it.
CNLs That Fail to Close Within the Lock Period Will Extend the Period at No Cost to the Borrower: If the borrower is primarily responsible for the failure to fund, the CNL may charge a fee for a lock extension, but must post that fee. If the CNL and borrower disagree on who was responsible for the failure to fund, the CNL agrees to accept the judgment of the professor.
For more on the network, see Finding a Mortgage on the Professor's Certified Lender Network.