When To Lock In Your Mortgage Rate

"I have been pre-approved for a loan on my new home but have yet to lock in the interest rate. When would be a good time to lock, and what indicators should I be looking at?"

This questionassumes that it is possible for mortgage borrowers (or their advisors) to forecast the direction of interest rates with a better than 50-50 chance of being right. In my view, that is wrong.

There are a lot of professionals out there who spend their entire working time analyzing the market, and who have a lot of money riding on the accuracy of their interest rate forecasts. Over time, virtually all approach 50% accuracy. Even if there are a few who do better than that consistently -- and I don't know who they are -- a non-professional doesn't have a chance.

The Federal Reserve targets two interest rates. One is the discount rate, which is the rate banks pay the Federal Reserve when they borrow. This rate is administered by the Fed and is wholly under its control. The second is the Federal Funds rate, which is the rate that banks charge each other on overnight loans. While the Fed does not administer this rate, it can control it by buying and selling securities, termed "open market operations". But these rates are only loosely related to rates on bonds and mortgages.

In developing your lock strategy, forget about trying to guess the direction of interest rates. The first thing to consider is your capacity to take the risk of a rise in market rates. If you barely qualify at today's rates and an increase would knock you out of the market, or force you to accept other unfavorable terms, you should lock immediately.

If you can withstand a rise in rates, there is a benefit in delaying the lock. If market interest rates don't change, the lock price falls as the lock period shortens. For example, a lender may quote a price of 7% plus 1.5 points on a 60-day lock and 7% plus 1 point on a 30-day lock. (One point is 1% of the loan amount). The reason is that the lender takes less risk with a shorter lock.

Working in the other direction, however, is that you lose the ability to walk away from your loan provider as the closing date approaches. This would not be a problem if the loan provider spelled out in advance exactly how the market price is determined on the day you lock. The only loan providers who do that, however, are Upfront Mortgage Brokers. They give you the best price quoted by their wholesale lenders and will show you the price sheets. For other loan providers, the market price on the day you lock is what they say it is.

On a purchase transaction, therefore, unless you have complete confidence in your loan provider, I would lock while there was still time to change loan providers. On a refinance, you can always change loan providers, so it's safer to delay the lock until shortly before closing. The loan provider, however, should be made to understand that you understand how the game is played.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania.