August 6, 2001
"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?"
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.
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.
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.
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.
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.
Copyright Jack Guttentag 2002
