INTEREST RATE LOCKS or DISCOUNT POINTS?

Most choose rate locks over discount points
By Holden Lewis • Bankrate.com

Homebuilders and their customers -- the ones who wait months for construction to be completed -- crave the same thing: certainty. That explains the appeal of long-term rate locks.

Uncertainty reigns over the home-construction process. Builder and buyer seldom know for sure when the house will be finished, and the final cost often is in doubt until late. And both sides worry about the impending storm clouds of rising interest rates, which can rain on the home-financing process.

It's no surprise that both sides shelter themselves from rising rates by making long-term rate locks. These rate caps are pushed by builders and embraced by buyers. But there's a riskier alternative: eschewing a rate lock and spending the money instead to get a lower rate. It's riskier because no one can predict if or when rates will skyrocket.

"It's impossible to tell which is going to be the best option for the borrower unless you're looking backwards," says Mark Dallal, vice president of secondary marketing for Homebuilders Financial Network, which operates in-house mortgage brokerages for homebuilders.

When choosing between a rate lock and discount points, borrowers don't have the benefit of hindsight.

A rate lock is the lender's promise that the mortgage's interest won't exceed a certain rate if the loan is closed by a deadline. For example, if you lock the rate at 6 percent 14 days before closing, and rates rise over the next two weeks, your loan's rate is 6 percent if you close on time. Meanwhile, someone who didn't lock -- who floated, in industry parlance -- would pay the higher rate.

Each lender handles rate locks differently. Most don't charge a fee to lock a rate within 30 days of the scheduled closing. Fees are common when the lock is beyond 30 days, and especially when it is beyond 60 days. The fees vary, and some lenders will refund all or part of the rate lock fee at closing.

Mortgages are like shaggy-haired car mechanics: caps usually cover long locks. If today's rate is 6 percent, a 180-day lock might cap the maximum rate at 6.5 percent instead of today's rate. A lot of long-term lock programs have a float-down option, which allows the borrower to seize and lock a lower rate shortly before closing if rates have dropped in the meantime.

Discount fees are more straightforward. The fees usually are expressed as points, where one point equals 1 percent of the loan amount. When you pay a discount point, the lender lowers the rate. The amount of the discount varies with the tides of the mortgage market, but one point usually lowers the interest rate by one-eighth to three-eighths of a percentage point. On purchase mortgages, discount points are deductible from federal income taxes. Rate lock fees are not tax-deductible.

The math is straightforward. What is the nonrefundable rate-lock fee and what is the rate cap? If you floated, and spent the money instead on discount points, how much would you be able to lower the rate? How high would rates have to rise in order for the discount points to be a bad deal? Finally, do you think rates will rise that much? If not, go with the discount points.

Buyers tend not to calculate things that way. They figure out what monthly payment they would be comfortable with, and lock accordingly. Such is the case with Clay Tingley, whose home is under construction in Danville, Calif. It is supposed to be finished in September. In February, Tingley got a 270-day lock through his builder's in-house mortgage broker. The fee was a quarter point, or $2,500 on a $1 million loan (it's California, after all).

His 5/1 adjustable-rate mortgage will have a maximum rate of 5.75 percent. He can float down once within 60 days of closing. He calls 5.75 percent his "comfort level threshold" or "affordability threshold."

"At 6 percent on my mortgage, I would feel uncomfortable with my monthly payments and begin to feel that the house was no longer affordable for me," he says. By locking far in advance, he adds, "I can sleep easier over the next five months."

Tingley didn't ask the lender what deal he would get if he paid the $2,500 to buy down the rate. Most likely, he would have been told that the minimum discount fee would be a half point or a full point.

Some lenders offer refundable rate-lock fees. You pay the fee upfront and it's credited to your closing costs as long as you stick with that lender. That's the deal that Wells Fargo offered Dave Demaree and his fiancée. In April they paid a 1-percent fee to lock the rate for 270 days. "Given the peace of mind we are getting with a locked-in rate, and the fact that we are in essence purchasing it with a deposit that we get back at closing, that's well worth it to us," Demaree says.

They could float, then pay one discount point ($1,800) later that would lower their rate by one-eighth or one-quarter of a percentage point. But Demaree would worry about rising rates in the meantime. The rate lock eliminates that worry.

A rate lock, then, is about psychology -- about alleviating anxiety. "I know a lot of people who would be happier to pay a higher rate and know that that's one thing that won't change before they move in," says Diane Saatchi, senior vice president of the Corcoran Group, which sells high-end real estate.

There's nothing wrong with that mindset, although a more hardheaded borrower might dismiss it. Someone such as Alex Beard, who recently had a home built, in the Dallas area.

"I came to see -- and am now more convinced than ever -- that it simply makes no sense to pay to lock way in advance," Beard says. "People who do so are just freaking out about the prospects of higher rates, when logic should tell them to just play it cool and keep an eye on rates."

The way Beard figures it, five things can happen to mortgage rates when you are waiting for your home to be built. They can drop substantially, fall a little, stay about the same, rise slightly or skyrocket. In the first four of those possibilities, it makes more financial sense to spend money on discount points than on a rate lock.

Even if rates do skyrocket, "you can still pay down the rate and get the tax deduction for paying the points, whereas you get no such benefit from paying to lock way in advance," Beard says. "You'll probably end up where you would have been had you locked way in advance, so you're really no worse for the wear."

That may be true if rates don't jump skyward. But they could, and that's a scary prospect. "Ninety-five percent of all financial decisions people make are rooted in emotion," says Bob Walters, chief economist for Quicken Loans. "When people lock an interest rate, it takes away an unknown. And people hate unknowns."

Walters' advice: Shop around. Builders pressure borrowers into using their affiliated lenders, but it's a good idea to apply at a couple of other places, too. Some lenders "dramatically mis-price" rate locks, he says, and you might as well take advantage of them if the rest of the deal looks good.

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