Question

When a bank makes a mortgage interest rate commitment, it agrees that its lending rate will be fixed subject to the loan application’s being accepted and other conditions of the loan being satisfied. The bank knows that if market mortgage rates rise, borrowers are likely to hold them to their commitment; but if rates fall, borrowers can choose to finance their mortgages at the lower rates. What options contact is a way to offset the risk the bank makes when fixing the mortgage interest rate in advance? Explain.

Answer 1

Options contract

An options contract is an agreement between two parties to facilitate a potential transaction on the underlying security at a preset price, referred to as the strike price, prior to the expiration date.

The two types of contracts are put and call options, both of which can be purchased to speculate on the direction of stocks or stock indices, or sold to generate income. For stock options, a single contract covers 100 shares of the underlying stock.

In general, call options can be purchased as a leveraged bet on the appreciation of a stock or index, while put options are purchased to profit from price declines. The buyer of a call option has the right but not the obligation to buy the number of shares covered in the contract at the strike price.

Put buyers have the right but not the obligation to sell shares at the strike price in the contract. Option sellers, on the other hand, are obligated to transact their side of the trade if a buyer decides to execute a call option to buy the underlying security or execute a put option to sell.

Options are generally used for hedging purposes but can be used for speculation. That is, options generally cost a fraction of what the underlying shares would. Using options is a form of leverage, allowing an investor to make a bet on a stock without having to purchase or sell the shares outright.

Mortgage interest rate

A mortgage rate is the rate of interest charged on a mortgage. Mortgage rates are determined by the lender and can be either fixed, staying the same for the term of the mortgage, or variable, fluctuating with a benchmark interest rate. Mortgage rates vary for borrowers based on their credit profile. Mortgage rate averages also rise and fall with interest rate cycles and can drastically affect the homebuyers' market.

The mortgage rate is a primary consideration for homebuyers looking to finance a new home purchase with a mortgage loan. Other factors also involved include collateral, principal, interest, taxes, and insurance. The collateral on a mortgage is the house itself, and the principal is the initial amount for the loan. Taxes and insurance vary according to the location of the home and are usually an estimated figure until the time of purchase.

A lender assumes a level of risk when it issues a mortgage, for there is always the possibility a customer may default on his loan. There are a number of factors that go into determining the mortgage rate, and the higher the risk, the higher the rate. A high rate ensures the lender recoups the initial loan amount at a faster rate in case the borrower defaults, protecting the lender's financial investment.

The borrower's credit score is a key component in assessing the rate charged on a mortgage and the size of the mortgage loan a borrower can obtain. A higher credit score indicates the borrower has a good financial history and is more likely to repay his debts. This allows the lender to lower the mortgage rate because the risk of default is lower. The rate charged ultimately determines the overall cost of the mortgage and the amount of the monthly payment. Therefore, borrowers should always seek the lowest rate possible.

Mortgage Rate Indicators

There are a few indicators potential homebuyers can follow when considering a mortgage loan. The prime rate is one indicator. This rate represents the lowest average rate banks are offering for credit. Banks use the prime rate for interbank lending and may also offer prime rates to their highest credit quality borrowers. The prime rate typically follows trends in the Federal Reserve’s federal funds rate and is usually approximately 3% higher than the current federal funds rate.

Another indicator for borrowers is the 10-year Treasury bond yield. This yield helps to show market trends as well. If the bond yield rises, mortgage rates typically rise as well. The inverse is the same; if the bond yield drops, mortgage rates will usually also drop. Even though most mortgages are calculated based on a 30-year timeframe, after 10 years, many mortgages are either paid off or refinanced for a new rate. Therefore, the 10-year Treasury bond yield can be an excellent standard to judge. You can use Investopedia's mortgage calculator to estimate monthly mortgage payments.