How Do Rate Locks Work?

In most cases when you shop for a loan, the rate and terms you are quoted represent those available that day. The rate quoted probably won't be available next month or next week. Therefore, you should only rely on the rate and terms a lender is willing to lock-in.

A lock-in, or rate commitment, is a lender's promise to close your loan at a certain interest rate and number of points. Depending upon the lender, you may be able to lock in the interest rate and points upon submitting your application, during application processing, upon loan approval, or later. A rate lock protects you against rate increases while your application is being processed. However, a locked-in rate could cost you money in the event rates drop and you want a lower rate.

You will need to lock the rate on your mortgage some time prior to closing. There are five components to a rate lock:

1. Loan program
2. Loan amount
3. Interest rate
4. Points
5. Length of the lock

You must identify each of the above mentioned items in a rate lock. A rate lock might look something like this: 30 year fixed, $150,000 loan amount, 7.5 percent, one point, 30 day lock period. The document describing the lock will contain the date the lock was made and usually the lock expiration date. The lender must disburse funds prior to the expiration of the lock period, otherwise, the rate lock is invalid.

A loan with a below-market interest rate is less attractive to a potential purchaser of the loan. The longer the lock period, the greater the risk that interest rates will increase before the loan closes. To offset this increased risk, the lender charges increasingly higher points and/or interest for longer lock periods.

If rates increase during the lock period and your lock expires, most lenders will let you re-lock at the new, higher rate or points. If rates decrease during the lock period and your lock expires, lenders usually will charge a penalty to take advantage of the new, lower rates. For a fee, some lenders allow a "float-down" option which allows you to take advantage of decreasing interest rates. Once a lock expires, be prepared to renegotiate the rate and points.

What do you do if the rates drop after you lock?

Unless you have the option to float-down, most lenders will not budge unless rates drop substantially (3/8 percent or more). Lenders incur fees when they lock loans. If lenders were to allow borrowers to cancel a lock every time rates improved, they'd spend too much time re-locking rates, and the increased costs would have to be passed to borrowers.

Lock and Shop programs.

Most lenders will let you lock an interest rate only in connection with a specific property. Some lenders offer lock-and-shop programs which let you lock a rate before you find your home. Both programs can be valuable when rates are rising.

New construction rate locks.

Most lenders offer long-term locks for new construction. Since these locks tend to be relatively long, they can be expensive. An up-front deposit is sometimes required also. Most long-term new construction locks offer a float-down.