Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

A 330-day rate lock?

Dear Dr. Don,
We are building a new home to be ready in April or May of 2004 in Northern Virginia. My question is anticipating a fed rate cut. Do you recommend us to lock (330-day lock) the rate now or wait till the rates are lower than the quotes below:

5/1 Jumbo ARM: 3.92 percent to 4.03 percent
7/1 ARM: 4.09 percent to 4.27 percent

Thanks,
Sam Survey

Dear Sam,
The longer the lock, the more expensive it is to lock in a rate. Start by considering the cost of a 330-day lock vs. other rate-lock maturities to decide what you're willing to pay for the certainty of locking in today's rate.

Price a float-down option that gives you a one-time opportunity to switch to a lower rate. Estimate what it will cost you to walk away from a rate lock if rates continue even lower. Rate locks with new construction can be particularly dicey if you can't close within the rate-lock period because of construction delays.

Adjustable-rate mortgages (ARMs) are priced at a spread to an underlying index like the Eleventh District Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR), or a Treasury Constant Maturity (CMT). Use Bankrate's Track Rates feature to follow movements in these rates.

An ARM that doesn't reset until five or seven years out also has to price in the interest rate risk that the lender faces by keeping your mortgage rate constant over the initial term. You can see how it affects interest rates in the difference between the 5/1 and 7/1 rates you presented in your letter. A reduction in the fed funds rate will be reflected in the ARM indexes but may have a different effect on longer-term interest rates.

If a rate cut is perceived by the financial markets as inflationary, longer term interest rates will increase on the news of a rate cut. Since 5/1 and 7/1 ARMs are a cross between an adjustable-rate and a fixed-rate mortgage, their rates may not follow the pricing index to lower levels.

Bankrate has a weekly Rate Trend feature that takes the pulse of the mortgage market by surveying mortgage professionals and reporting where the pros see rates heading. You can have this feature delivered to your electronic mailbox every Thursday in an editorial alert, or just visit the site to get this week's read on the mortgage market.