Should I Lock In My Interest Rate?

The interest rate on your loan is not automatically fixed when you apply for a loan. Unless you lock in the rate, the rate on your loan will "float" based on market conditions. Should you lock in?

The Case for Locking In

If you think that interest rates will increase before you close on your house, you should consider locking in. There are three main reasons to lock in.

• Interest rate stability. Locking in guarantees that the lender will fund your mortgage at the agreed-upon interest rate, with the agreed-upon discount points.
  
  
• Peace of mind. If you are risk-averse, there is comfort in knowing that your interest rate will not rise at closing.
  
  
• Loan approval. If you have not locked in and interest rates rise, the lender could reconsider your loan application, perhaps denying your loan or asking for a larger down payment.

Lenders charge a fee to lock in. The fee is usually a percentage of the loan; the longer the lock-in period, the greater the percentage.

The Case for Floating

On the other hand, if you think that interest rates will decline between the day you apply for the loan and the day you close on the loan, you might let the rate float. Floating has the following advantages.

• Opportunity for lower interest rate. If interest rates do decline, you will be rewarded with a lower monthly payment and reduced interest expense.
  
  
• Flexibility. If interest rates fall, you can change your mind about floating and lock in at a more attractive rate. (Note: Your lender may limit your ability to lock in as the day of closing approaches.)
  
  
• Zero fee. There is no charge to float a loan.

Of course, if rates increase, you may pay a penalty for floating - increased interest expense and a higher monthly payment.

A Framework for Decision-Making

It is impossible to know with certainty whether it will be better to lock in or float the interest rate. However, you can improve the odds of making a correct decision. This section describes how.

First, you need to understand what constitutes a good lock-in decision. Most home buyers believe the following:

• Home buyer locks in. If rates rise, this was a good decision, since the home buyer locked in at a lower rate. If rates fall, the decision was bad.
  
  
• Home buyer lets rate float. If rates fall, the decision was good; and if rates rise, the decision was bad.

The above analysis is too simplistic, and not always correct. It ignores the cost of locking in. Suppose, for example, that the home buyer decides to lock in. For that decision to be correct, it is not enough for interest rates to just rise; they must rise enough for the added interest expense to exceed the cost of locking in.

Therefore, to make an informed lock-in decision, it would be helpful to know how much interest rates would have to rise to cover the cost of locking in. Using this site's mortgage calculator, the analysis is easy. To see how it is done, review the lock-in case study.