Should I Lock In a Mortgage Rate?

Mortgage interest rates change daily. The rate that is available when you apply for a loan may not be the rate that you see weeks or months later at closing.

Home buyers have two choices. They can let the rate float, or they can lock in.

What Makes a Good Lock-In Decision?

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.

First, you need to understand what constitutes a good lock-in decision. Some home buyers believe that they have made a good lock-in decision if the interest rates increase after they lock in.

This is not always correct, because it ignores the cost of locking in. For the lock-in decision to be correct, interest rates cannot 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, you need to know how much interest rates would have to rise to cover the cost of locking in. The following case study shows how to figure this out.

How to Compute the Costs and Benefits of Locking In

Selena is buying a new home for $300,000 - the fair market value of the home. She will make a down payment of $30,000, so Selena needs a $270,000 loan. She a chosen a fixed-rate mortgage. The lender requires private mortgage insurance (PMI) payments of $1,800 per year.

The current interest rate is 7%. The lender will lock in that interest rate for 1% of the loan amount (i.e., $2,700).

If she doesn't lock in, other costs (e.g., closing costs) amount to $3,000. If she does lock in, other costs will equal $3,000 plus the $2,700 fee to lock in or $5,700.

Selena is worried that the interest rate will rise to 7.125% if she lets the rate float. Assume that Selena plans to live in the her new home for 5 years. Would she be better off to lock in or let the rate float? The details of each option appear below. (Note that the lock-in fee shows up in the "Other costs" category. Other costs are $3,000 when Selena lets the loan float; $5,700 when she locks in.)

To compare the options, Selena uses this site's mortgage calculator. The first step is to describe the analysis she wants to conduct.

• Choose "Compare two mortgages" from the Main Goal dropdown box of the calculator.
• Be sure the "Show amortization schedule" checkbox is checked.
• Be sure the "Include mortgage insurance" checkbox is checked.
• Under Loan 1, choose "Fixed-Rate Mortgage" as the mortgage type.
• Under Loan 2, choose "Fixed-Rate Mortgage" as the mortgage type.

The calculator then prompts Selena for the data it needs, and Selena enters data from the above description into the calculator. For the lock-in option, Selena enters $5,700 for "Other costs", to account for closing costs plus the cost to lock in. For the float option Selena enters $3,000 for other costs, since she is not paying the $2,700 lock-in fee. The calculator settings and data entries are shown below.

After Selena clicks the Calculate button, the calculator produces an amortization report that shows the total mortgage cost for each option. The amortization report shows the total cost for each month of the loan. Since Selena will only live in the home for 5 years, she focuses on the total cost at the 5-year mark (60 months).

After 5 years, the total mortgage cost for the lock-in option (7% interest, with $2,700 lock-in fee) is $406,634; and the total cost for the float option (7.125% interest, with no lock-in fee) is $405,634. Conclusion: Even if the interest rate increases to 7.125%, it will be cheaper to let the rate float than to lock in.

But what if the interest rate at closing floated to some different value? You can easily repeat the analysis to assess the outcome for any interest rate. The table below shows the result at a variety of interest rates.

This analysis shows that letting the rate float is the best decision, until the rate floats to 7.25% or higher.

Conclusion

This kind of analysis gives a home buyer the information needed to make an informed decision. In the example presented above, Selena can see that interest rates would have to increase to 7.25% for locking in to be the right financial choice. On the other hand, if the prevailing rate at closing is 7.125% or less, then letting the rate float is the right choice.