Chris Bennett and Erin Palmer: Extended Rate Locks–How to Hedge Your Bets Past 90 Days

Chris Bennett is principal of mortgage industry hedge advisory firm Vice Capital Markets. He can be reached at cbennett@vicecapitalmarkets.com.

Erin Palmer is Founder and CEO of Blue Phoenix. He has held a number of executive leadership roles over the past 25 years. He has served as an Executive Advisor through the Teraverde Alliance to banks and mortgage bankers in these specialties. He currently serves as a board member for the Michigan Mortgage Lenders Association.

For some lenders, the term “extended rate lock” conjures thoughts of a 90- or 120-day lock, but in today’s market, the only truly extended rate locks lenders should be considering are those required as part of new construction loan products. Given that no construction project is a carbon copy of another, extended rate locks are not necessarily a “one-size-fits-all” option.

Putting aside the extended rate lock period, one of the most significant differences between a conventional construction product and purchasing an existing home is the choice of one or two closings. Thankfully, the second one is less extensive, but before selling a loan to a government sponsored enterprise (GSE), the credit and appraisal documents should all get a second look at the end of the extended rate lock period.

Even with the one-time closing product, a lot can happen over the course of construction so ensuring the continued eligibility of the loan for eventual sale throughout the construction process is an additional strategic requirement. While any new construction loan destined for sale to a GSE can be a one- or two-time close, lenders can decrease risk by focusing the right resources on the initial underwrite as well as the final review.

Adding Fees, Not Rates

There are several ways for lenders to mitigate risk while still meeting the borrower’s needs when offering extended rate locks. One of the main concerns is the interest rate itself. To protect against potentially volatile interest rates, some lenders will attempt to add points up front to the interest rate. While this may look attractive at the outset, it can backfire if rates are stable or down when the rate lock ends; the borrower could quickly refinance with a different lender, erasing that servicing value created or, even worse if sold to an investor, resulting in early payoff (EPO) penalties. On a two-note closing or hedged end loan, baking those costs into the rate can in many rate environments result in an end rate at which the borrower simply will not close. One solution is to cover the cost that borrowers pay upfront, defining it as the cost to lock that rate for such a long period of time.

Ensuring Salability

Salability is one of the most critical factors for any lender to consider when originating a loan. For lenders selling new construction loans to investors, the best course of action is to look at the investor’s extended rate lock program, mimic it, offer it to borrowers and lock it down. From an operations standpoint, it’s critical to ensure everything happens in the correct order and at the right time because the investor is a correspondent partner to the lender throughout the entire process, not just a buyer at the end of the line.

Lenders with GSE relationships have several different options in front of them, but two lock types are most prevalent. The first is a firm rate lock, in which the lender locks the borrower at a reasonable market rate that will not change, no matter what happens to the market. This aligns with the one-time closing process. To hedge a firm rate lock, lenders need to account for the cost to roll the hedge from month to month. A conservative value is a quarter point per month, charging for each month beyond the standard 60-day lock. This allows lenders to hedge the loan and recoup adequate compensation for the roll during the construction period.

As noted above, covering those additional hedge costs by simply adding to the rate is not suggested, as the borrower is left with an inflated and above-market rate more often than not, and in the case where only the end loan is being offered (for a home built by a production builder), it may be quite difficult to get the borrowers to close at such a now above-market rate. Therefore, the fee associated with a firm rate lock should be assessed as an upfront fee and can be explained to the borrower as the cost to buy the rate lock for the extended period.

A float-down feature is the second lock type most prevalent among lenders with GSE relationships. This product allows borrowers to float down from their locked rate to the current market rate, or somewhere close to the current market rate, within 15 days of closing. This aligns with the two-time closing process. As a result, borrowers feel more confident that they won’t get stuck with an above-market interest rate or be unable to afford their monthly payments. Unfortunately, this product doesn’t offer an easy hedging solution, and lenders must be comfortable taking a risk when presenting it to borrowers. This is often an acceptable risk for lenders that only originate a small percentage of new construction loans or depositories with “the power of the portfolio” as a backstop.

Or Holding On

For depository institutions looking to hold new construction loans in portfolio, an additional option is available that can be attractive to both the lender and the borrower. With a one-time close on an adjustable-rate mortgage (ARM), the note date begins at the start of the construction period. The lender is protected because they’ve begun collecting interest on the loan during the construction period, while the borrower enjoys the security of a fixed payment for a set number of years. Additionally, the adjustment period protects the lender against changes in short-term interest rates.

What’s Old is New Again

When looking at new construction loans, some lenders overlook that many of the same rules will also apply to their renovation programs. More than 80% of what lenders need for a successful new construction program will map perfectly onto a renovation program. The only additional variables to consider for renovation programs are how informed the borrower is and how effective the lender’s checkups with either the loan officer, processor or draw administrator are.

With renovation loans, borrowers should understand that the lender must take certain steps before authorizing the request to draw funds for completed work. This includes completing a property inspection to ensure the work passes code and conducting a title search to ensure there are no mechanics liens on the property. It’s also critical in construction and renovation loans that the borrower understands that it is their responsibility – and not the lender’s – to manage the relationship with the builder or contractor. The lender is only there to facilitate the draw to ensure the completion of these tasks. Without that understanding, the lender is placing themselves at additional risk because of any number of issues that could arise toward the completion of the construction process.

For depository institutions that are also handling the construction loan itself and not just the end mortgage after a Certificate of Occupancy is issued, net interest income during the entire construction process is an important part of that loan’s additional profitability that should be weighed and valued when devising a cost and rate structure for the final loans, either as a one-note closing or a two-note closing. With net interest income averaging roughly half the final loan amount, an average construction loan can provide $6,000-$9,000 of additional income that can be leveraged to provide even more competitive pricing for the end mortgage.

For lenders extremely comfortable with the 60-day lock period, the idea of an extended rate lock that could go anywhere from six to 24 months may sound like a risk that’s too big even to consider. However, with the right information and considerations, lenders can definitely mitigate the risk associated with extended locks. Having this ability can be a real strategic advantage in the right markets.

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at msorohan@mba.org; or Michael Tucker, editorial manager, at mtucker@mba.org.)