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October 30, 2001, Revised July 10,
2002
"I
heard an ad by a lender on the radio this morning that said, in effect, that if
I borrow from them I don't have to worry about rate increases because they would
lock the rate, yet if interest rates go down they will reduce the rate.
How can they do this, or is it some sort of scam?"
No, it isn't a
scam, it is what is sometimes called a "float-down".
A float-down provides the same upside protection as a lock, plus an
option to reduce the rate if market rates decline.
Like a lock, a float-down is an option that can be attached to any kind
of mortgage. Since it carries more
value to the borrower than a lock, however, and is more costly to the lender to
provide, the borrower pays more for it.
On a lock, the
lender promises that the loan terms agreed upon will be honored when the loan
closes, regardless of what happens to market interest rates in the meantime.
The borrower is bound by the lock if interest rates go down, and the
lender is bound if they go up.
Borrowers,
however, sometimes walk away when rates go down, provided they have enough time
and the inclination to start the process over again with another lender.
To prevent this, some lenders charge a non-refundable fee that borrowers
lose when they walk, but many do not.
With a float-down
borrowers have the right to have the rate reduced.
They need not walk out on their obligations, relinquish any fees they
have paid, and start the loan search all over again.
Usually the right can be exercised only once, at which point the
float-down converts to a lock.
But a float-down
comes at a price. For example, a
price sheet I recently looked at showed that on a 30-year fixed-rate mortgage at
8.5%, the lender charged 1.625 points to lock the rate for 120 days. (A point is
1% of the loan amount). The
comparable price for a float-down was 2.625 points.
The borrower was thus paying 1 point for the right to take advantage of
any reduction in market rates that occurred within the 120 day period.
"I have a
rate lock with a float down, and rates have gone down since the lock.
However, my mortgage broker says that he can't float down until the week of the
close, and only if the rate is more than 1/4% lower. Is that right?"
Probably.
Float-down terms are set by each lender who offers them -- there is no standard
contract.
Of course, the
broker should have explained the exact terms of the float-down going in.
These include when you can exercise, any minimum decline in rate or points, and
how the current market price is determined and communicated to you.
The last point is
worth stressing. I would not pay for a float-down where the market price
is communicated to you over the telephone. You should get a copy of the
price sheet with the relevant price circled at the time you lock, and then again
when you get to the exercise period. That's how you know you are getting
what you paid for.
"I read your article about the
distinction between a lock and a float-down, and why a float-down is more
expensive. But it seems to me that if I�m refinancing, there isn�t any point
in paying for a float-down, because if interest rates go down, I can just let
the lock expire and lock again. Is there something wrong with my logic?"
If you allow a lock to expire, waiting
for rates to go down, the lender providing it will not lock another loan for you
for some period -- often 60 days. If rates decline near the end of the
lock period and there isn't time to close, the lender will probably be willing
to extend the lock period, but at the original price, not the improved
price. So if you play the waiting game, you may be forced to go to another
loan provider.
That inconvenience aside, your logic is
sound. Your morals, however, are shaky: you committed yourself to the terms in
the lock and by allowing it to expire so you could get a better rate, you are
reneging on that commitment.
On a lock, both and the lender and the
borrower promise that the loan terms agreed upon will be honored when the loan
closes, regardless of what happens to market interest rates in the meantime. The
lender is bound by the lock if interest rates go up, and the borrower is bound
if they go down.
On a float-down, the lender is committed
to the terms agreed upon if interest rates go up before closing, but if rates go
down the borrower has the right to lock again at a lower rate. Since this
imposes an additional cost on the lender, the price of a float-down is higher
than the price of a lock.
A borrower who accepts a lock but allows
it to expire when interest rates go down so he can lock again, is in effect
getting a float-down at the lock price. I call them "lock-jumpers".
While lock-jumping is difficult to do on a purchase transaction where the
borrower has a closing date that must be observed, on a refinance, it is easy
� much too easy.
Lock-jumpers raise the cost of locks to
lenders, who pass on the cost to other borrowers who don�t play. In this
regard, lock-jumping is like shop-lifting. And just as merchants have an
obligation to make it difficult to shop-lift, lenders have an obligation to make
it difficult to lock-jump.
A case can be made that lenders should
offer only float-downs on refinance transactions because that�s what
refinancing borrowers really want. Conventional locks result in under-pricing to
lock-jumpers and over-pricing to everyone else.
Copyright Jack Guttentag 2002
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