Price protection

Ask the mortgage professor

Price protection to good to be true?

Monday, September 04, 2000 By Jack Guttentag
Inman News Features

"I heard an ad by a lender on the radio this morning that said, in effect, that if I borrow from them I don't have to worry about rate increases because they would lock the rate, yet if interest rates go down they will reduce the rate. How can they do this, or is it some sort of scam?"

No, it isn't a scam; it is what is sometimes called a "float-down". A float-down provides the same upside protection as a lock, plus an option to reduce the rate if market rates decline. Like a lock, a float-down is an option that can be attached to any kind of mortgage. However, since it carries more value to the borrower than a lock and is more costly to the lender to provide, the borrower pays more for it.

On a lock, the lender promises that the loan terms agreed upon will be honored when the loan closes, regardless of what happens to market interest rates in the meantime. The borrower is bound by the lock if interest rates go down, and the lender is bound if they go up.

Borrowers, however, sometimes walk away when rates go down, provided they have enough time and inclination to start the process over again with another lender. To prevent this, some lenders charge a non-refundable fee that borrowers lose when they walk, but many do not.

With a float-down, borrowers have the right to have the rate reduced. They need not walk out on their obligations, relinquish any fees they have paid, and start the loan search all over again. Usually the right can be exercised only once, at which point the float-down converts to a lock.

But a float-down comes at a price. For example, a price sheet I recently looked at showed that on a 30-year fixed-rate mortgage at 8.5%, the lender charged 1.625 points to lock the rate for 120 days. (A point is 1% of the loan amount). The comparable price for a float-down was 2.625 points. The borrower was thus paying 1 point for the right to take advantage of any reduction in market rates that occurred within the 120-day period.

What Is a Demand Clause?

"Is a demand clause the same thing as a due on sale clause? I shopped for a loan at several lenders, and the information on requirements was very similar among them except that one lender stipulated that the note would include a demand clause. "

A demand clause is even better (for the lender) than a due on sale clause.

With a due on the sale clause, the loan must be repaid upon sale of the property. Its purpose is to protect the lender in a rising interest rate market. Lenders are concerned that borrowers with low-rate loans who sell their homes will arrange for the buyers to assume the loans. Lenders want these loans repaid so they can make new loans at higher rates.

A demand clause allows the lender to demand repayment for any reason. It protects the lender against having low-rate loans assumed by homebuyers in a rising rate market just as effectively as a due on sale clause. But in addition, a demand clause permits the lender to raise your interest rate in a rising rate market even when you are not selling your house. The lender can force you to accept a higher rate by threatening that if you don't agree, the loan will be called.

The lender requiring a demand clause will no doubt disavow any intention of behaving in such a manner. But in my view you don’t put your head on a chopping block just because the executioner promises not to cut it off.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.

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