Brokers don't have to have the ability to forecast rates, but they don't have to. Because of the way the market works, the broker wins if interest rates don't change between the lock date and the closing date, or if rates decline. Brokers only lose if rates increase appreciably during the lock period
Consider a borrower who wants rate protection for 60 days. His mortgage broker shops the market for the best wholesale prices. The price on a loan delivered today (the "float" price) is 8%, plus 1 point (each point is percent of the loan). The price on a loan delivered within 60 days (the 60-day lock price) is 8% plus 1.5 points. The broker adds a markup of, say, 1.5 points to the 60-day lock price, making the final cost 8% plus 3 points.
The difference of 0.5 points between the float price and the 60-day lock price reflects the lender's "lock-jumping" risk. If interest rates increase during the 60-day period, the lender is nevertheless committed to delivering the lock terms. But if interest rates decline, the borrower may walk away and negotiate a cheaper loan elsewhere.
Since the borrower in the example wants the rate protection, the mortgage broker provides it. The borrower is guaranteed that the loan will close at 8% plus 3 points. If the broker locks the loan with the lender, the lender gets 1.5 points and the broker makes 1.5 points.
Alternatively, the broker may lock the loan at his own risk. If so, and if interest rates don't change during the 60 days, the loan will be delivered to the lender at the float price, or 8% plus 1 point. The borrower pays 3 points, as before, but the broker makes 2 points instead of 1.5.
If interest rates increase during the 60-day period, the broker could lose the extra profit, and even the markup. If the float price after 60 days turns out to be 8% plus 3 points, for example, the broker will make nothing on the deal.
If interest rates decline, on the other hand, the broker will make more than 2 points, assuming the borrower stays with the deal. If the borrower threatens to walk, the broker will be forced to share some of the benefit of the rate decline. For this reason, gains from rate declines don't fully offset losses from rate increases.
Brokers who lock at their own risk believe that the profits they earn in a stable market will be greater than their losses from market fluctuations. Through most of the 1990s, losses have been small because market fluctuations have been small.
Is the practice kosher? Brokers believe it is because the borrower is protected. Brokers absorb the loss if interest rates go against them. But it is fair-weather protection that disappears when the consumer needs it most -- during an interest rate spike.
For example, in the two-month period January-March, 1980, mortgage rates jumped from 12.88% to 15.28%. A broker who locked for 60 days at 12.88% would have to pay a lender about 15 points to accept a loan with that rate in a 15.28% market. The broker would either go out of business, or deny that a lock was given. (Broker locks are oral commitments.) The borrower would be left high and dry in either case.
Broker locks are a deceitful practice because the borrower is led to believe that the lender is providing the lock. To protect yourself, insist on receiving the rate lock commitment letter from the lender identifying you as the applicant.
