Buying a house is the largest purchase that most people ever make. Although there are a few people with the financial resources to pay cash for their new home, everyone else has to think about what kind of mortgage loan to get and how much they can afford. With home prices still near record highs, you have to do everything you can to make your money go as far as it can.
Once you've gone to all the trouble of finding a mortgage you can live with, you'll want to count on that mortgage being there for you at closing. Yet what many prospective homebuyers don't understand is that the rate they're originally given for their mortgage quote isn't necessarily the rate they'll actually receive when they complete their home purchase. If your mortgage broker or financial institution doesn't offer a "rate lock" feature that ensures that your rate will stay constant, you could end up paying significantly more in interest and monthly payments than you initially thought.
Mortgage rates and volatility
In general, the fixed-income markets have a reputation for being less volatile than their stock-market counterparts. Typical asset allocation models urge investors to put a portion of their money in fixed-income securities precisely to enjoy the benefits of having a more stable type of asset with which to diversify their overall portfolios. Because mortgage rates tend to follow the movements of rates offered on certain fixed-income securities, such as Treasury bonds, it's tempting to conclude that there's little danger of having prevailing interest rates move so much that your lender will have to adjust the rate on your mortgage.
Historically, lending rates have tended to bear out this lack of concern. When you look at changes in interest rates over 60- to 90-day periods, which represent the typical amount of time between when most homebuyers make their initial offer and when they close on the transaction, you'll most often see little or no change in rates. Moves of more than 0.25% have been fairly rare. In addition, on average, it's just as likely that rates will move down as up, which can create some unexpected savings for you.
However, according to historical data provided by Freddie Mac, there have been a few periods during which mortgage rates moved precipitously within a span of just a few weeks or months. For instance, during 2003, average mortgage rates rose more than a full percentage point between June and August. In 2004, a similar upward spike in rates occurred between March and May, resulting in a rise of more than 0.8%.
Little moves, big money
This relative lack of volatility may give borrowers some comfort that their mortgage rate isn't likely to change dramatically at closing. However, if buying a home is pushing you to the limit of your financial resources, even a small change in rates can make a big difference. For example, if you borrow $250,000 on a 30-year mortgage at 6%, your monthly payment will be about $1,500. If your rate ends up being just a quarter-point higher, then you'll pay about $40 more each month. Over the course of 30 years, that adds up to $14,400 more in interest that you'll pay, all because of that small rise in rates.
More importantly, a change in rates may jeopardize your ability to qualify for the loan you want. If you're right at your borrowing limit based on your income and financial assets, then even the small additional cost involved with a higher interest rate may lead some lenders to urge you toward an entirely differently type of mortgage. In the last-minute rush to get your transaction completed, you may feel that this resembles a bait-and-switch tactic designed to steer you into a particular mortgage product. Although many reputable lenders will let you keep the mortgage even if you wouldn't have qualified for it based on the rates when you first applied, even modestly higher payments can force your budget past the breaking point.
Paying for rate locks
If your lender offers a rate lock at no extra charge, then you should generally take it, unless you have reason to believe that rates will fall before your closing date. However, in some cases, your lender will charge you to lock your rate. How much you have to pay depends on how long the rate lock extends; for instance, a 90-day lock could cost a substantial amount, while a 15-day lock might not cost anything. In addition, you may find interesting variations on rate locks. Wells Fargo
While accepting the peace of mind that a rate lock can provide makes sense when it doesn't cost you anything, paying for the privilege doesn't always win in the long run. Depending on the length of the rate lock, you might have to make an up-front payment of between $625 and $2,500 on a $250,000 mortgage. Even if the rate lock ends up lowering your monthly payment, you may sell your home or refinance your mortgage before those savings make up for the rate-lock fee.
Whether you should lock your mortgage rate depends on how comfortable you are gambling with the biggest purchase of your life. With all the other uncertainties involved in buying a home, it can be comforting to know that at least one element of your future life as a homeowner is set in stone.
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Fool contributor Dan Caplinger is on the verge of getting his mortgage rate locked -- finally. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy is one constant in an unpredictable world.
