A rocky transition to double-digit mortgage rates

For the last 24 years, mortgage interest rates have been in the single digits, supporting a widespread presumption in the industry that this is the normal state of affairs. Yet the rate was 10 percent or higher during most of the 11-year period of 1979-1990.

Given this history and the current outlook for the economy and monetary policy, it is prudent to consider the consequences of a return to double-digit rates, and to take whatever measures are available to soften their impact. The need for preventive measures is particularly acute in the reverse mortgage market.

The focus of this article is the transition from the current 4-percent to 5-percent market to a 10-percent market. Problems associated with the higher rate level - living with a 10-percent rate rather than a 4-percent or 5-percent rate - will be discussed in another article.

Transition to a 10-percent, forward mortgage market:

The transition problem arises out of the impact of rate increases on mortgage applicants who have loans in process that have not yet been locked - the final rate has not yet been set. These applicants have made decisions to proceed based on one set of rates, and have incurred expenses in the process, perhaps including a nonrefundable purchase deposit, only to find themselves forced either to pay a rate higher than they had expected, or to drop the deal and count their losses.

Every time there is a rate spike, mortgage applicants who are not locked must either pay up or give up. The shorter the period in which the rate increase is concentrated, the larger the fallout and losses.

Unlocked applicants caught by a rate spike fall into four groups. The first group do not yet meet lock requirements because their applications have not been fully processed; perhaps their appraisals have not yet been delivered, or problems may have emerged in connection with their credit. A second group meets all the requirements to lock but needs a longer lock period than the 60 to 90 days customarily available, usually because they have a house under construction. The third group consists of "floaters" who could lock but choose not to because they believe interest rates are going down, or at least rates will be stable and they will avoid the lock fee. A fourth group believes themselves to be locked but aren't because the lenders who locked them did not hedge their own positions and will be unable to honor their locks when the interest rate spikes.

There are no statistical data on the number of unlocked applicants in the forward market, but my rough guess is that it is less than 10 percent of all applicants. Further, the great majority of borrowers are aware that their rate is not final until it is locked. Unless rate increases in the future are more concentrated in short periods, the fallout and losses from future rate spikes should be similar to those we have had in the past. Those who are caught will be seriously hurt but the market will go on as before.

Transition to a 10 percent reverse mortgage market:

The impact of rising rates on the reverse mortgage market could be much worse, perhaps devastating. This market has never been tested by rising rates, since it was just getting started when the period of double-digit rates was ending in the early 1990s.

It is much more vulnerable than the forward market, for two reasons.

First, most reverse mortgage applicants on any given day are unlocked. In part, this is due to the longer processing period, which among other things reflects the legal requirement that every borrower must be counseled. But the major factor is that locks are not available for periods longer than two weeks. Loans are not contractually locked until shortly before closing, and therefore they provide very little protection.

The second difference is that most forward borrowers are aware of their exposure to a rate increase if they aren't locked while most reverse mortgage borrowers are not. In good part, this reflects how reverse mortgage lenders have responded to the combination of long processing periods, short lock periods, and unsophisticated clients. Their practice is to voluntarily lock the rate that prevailed when the applicant was first told how much could be drawn, even though this might be higher or lower than the market rate on the lock day. This avoids having to explain to the client early on that the amount available to them won't be known for sure until shortly before they close.

While close scrutiny of the Good Faith Estimate that the applicant receives shortly after applying will reveal that the rate is not locked, the disclosure is oblique and few seniors grasp it.

The practice of providing voluntary but non-contractual rate locks is encouraged by the relatively large markups that prevail in this industry. A smaller markup is viewed as better than a disgruntled borrower.

This practice works only so long as rate increases are small enough to be accommodated by lenders through tolerable reductions in their markups. If the transition from 5 percent to 10 percent is slow and steady, all will be well. However, expecting that is wishful thinking. It is very unlikely that lenders can absorb a rate increase larger than 1 percent. Yet there were at least four occasions during the years 1979-81 when the increase exceeded 1 percent within one month, and three additional periods when the rate rose by more than 1 percent over two months.

A rate spike that is too large to be covered by a reduction in lender markups would pose a major threat to the viability of the reverse mortgage market. The failure to deliver would be widespread because most reverse mortgage applicants in process are unlocked, and they will all claim with good reason that nobody warned them that this might happen.

The media will portray the episode as the exploitation of senior homeowners by greedy lenders - and resolutions will be introduced in the Congress to fold up the HECM reverse mortgage program.

One way to prevent any such scenario is to develop and deploy longer lock periods, at least comparable to those available in the forward market. But that will require an industry effort that includes the secondary market players along with Ginnie Mae, the Government National Mortgage Association. It could take years even if the process were to start tomorrow.

A second approach, which can be adopted by individual lenders, is to scrap the practice of providing voluntary but nonbinding locks, instead locking at the price prevailing on the lock day - just as it is in the forward market. To make this acceptable to borrowers, the lender needs to provide an early disclosure that makes crystal clear that applicants assume a rate risk associated with market volatility, but that volatility works in both directions and they will benefit if rates decline. I have developed such a disclosure and will provide it free to any lender who requests it.

To make the message fully credible, however, the applicant must be able to monitor their rate at any time prior to the lock day. While only a few lenders offer this feature to their clients today, the technology required is relatively simple and readily available.

Implementation of this approach will not prevent a rate spike from torpedoing deals and making unlocked applicants unhappy. However, it will clarify that market changes work in both directions, that the applicants who were caught by the spike had been warned about the risk, and that they had not been abused by the lender.

• Contact Jack Guttentag via his website at mtgprofessor.com.

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