When a borrower locks a rate with a lender, the lender promises to hold that rate for the borrower until the loan closes. But there is a deadline and moving that deadline back costs money. Depending on what the mortgage rates are doing, this sometimes makes perfect sense to everyone, but other times, it seems counter-intuitive. This is the story behind the “extension fee”.
The Risk of the Borrower Lock
When a lender takes a rate lock, it takes on risk. The lender grants a lock today on a promise by the borrower to close a loan in the future, say 30 days later. Between today and the day the loan closes, the market is likely to fluctuate at least a little, and sometimes quite a lot. This leaves uncertainty about whether the lender made a good deal. Here’s a quick example:
On January 1, Mr. Borrower locks a rate of 5%, for which investors of mortgages are willing to pay 100.00*, or par, on that day. This means that the investor will pay dollar for dollar for the mortgage – the investor purchases a $100,000 loan for $100,000. However, on January 30 (the day of closing), mortgage investors have decided they are willing to pay 101.00 ($101,000 for the same loan). In this case, the current mortgage rates advertised are lower than they were at rate lock. The lender now has a loan that it can sell for a premium 1% higher than it thought when it granted the lock. Great for the lender, right?
At first look, it would seem that if the lender can get more money for the loan, it should be willing to grant a free extension. But if mortgage investors had instead soured on 5% rates, they might pay only 99, or $99,000, leaving the lender with a 1% loss. So, this is turning out to look like a bet and no smart lender is in the business of gambling. So the lender must protect itself from fluctuating markets, called “interest rate risk”.
The Hedge Against Interest Rate Risk
Lenders mitigate interest rate risk by hedging the locks granted to borrowers. There are a number of ways to do this, but all work toward the same end result. Consider that a rate lock is an agreement between lender and borrower – the lender promises to close a loan at a particular rate and in exchange, the borrower agrees to close the loan. When the lender makes this commitment, it takes on interest rate risk, which it offsets, or hedges, by performing an opposite transaction.
Back to Mr. Borrower’s lock . . . when the lender grants a lock of 5% to Mr. Borrower, it does so on the fact that mortgage investors are willing to pay 100 for that rate. Rather than wait until the closing date and hope that investors are still willing to pay at least that, the lender makes an immediate promise to a mortgage investor to deliver that loan, at that rate, at a future date in exchange for a commitment from the investor to pay 100, regardless of current prices when the loan closes. The lender and the mortgage investor now have a deal that is essentially tied to the borrower’s lock.
The Cost of Time
Investors make decisions on what price they are willing to pay based on risk factors, one of which is time. Given a preference, investors prefer to make decisions based on known facts, and they prefer to execute their investment immediately. When an investor promises today to make an investment at some point in the future, (at the date of closing, for example) the state of the market at that future date is unknown, and therefore a risk. The longer the time the investor agrees to wait for the investment, the more risk he takes, and the more compensation he requires.
The Extension Fee
On Mr. Borrower’s lock . . . the lender received the borrower’s commitment to close a 5% mortgage on January 30. The Lender in turn committed to deliver a 5% mortgage to an investor. If the borrower requests to close that note 15 days later**, the Lender will not be able to fulfill the commitment to the investor at the same price – the investor wants more money to compensate for the additional risk of time. This is the extension fee.
What About the Current Market?
Note that the current market is not a factor in the extension fee. Remember that the lender wisely determined that gambling on mortgage rates is not prudent business and hedged the interest rate risk by making an offsetting commitment to an investor. When the loan actually closes on January 30th, the commitments from the borrower, the lender, and the investor, are all based on the market the day the lock was granted — the current market at not a factor at all.
In conclusion, the mortgage investor, and his need to be compensated for the risk of time, is the ultimate driver of the extension fee.
* The interest rate and market prices are hypothetical only, chosen to make illustration simple. They do not represent current market prices.
** There are additional factors that contribute to the cost of time for mortgages, such as security pool dates and a lender’s ability to make that pool date. However, for the sake of simplicity, those details are left out of this discussion. The logic remains the same.