A forward commitment agreement is a legally binding contract between two parties to buy or sell a specific asset at a predetermined price on a future date. Widely used in the mortgage industry and other financial sectors, these agreements help manage price uncertainty by locking in terms before the actual transaction takes place.
How Forward Commitment Agreements Work
The most prevalent use of forward commitments is in the mortgage secondary market, where lenders and investors arrange sales of loans before loan closing. For example, a local bank (the seller) originates a fixed-rate mortgage and agrees to sell this loan to a large investor like Fannie Mae or Freddie Mac at a locked-in price to protect against rising interest rates during the loan closing period. This agreement ensures the lender receives a guaranteed price, while investors secure a predictable yield on their investment.
This type of contract is typically negotiated privately (over-the-counter) and tailored to the specific loan or asset involved. It carries an obligation for both parties to complete the transaction at the agreed price and time, differing from options which only grant the right but not the duty to transact.
Common Applications
- Mortgage Lenders: Use forward commitments to reduce exposure to interest rate changes during loan processing.
- Secondary Market Investors: Rely on these agreements for steady mortgage-backed securities acquisition.
- Commercial Real Estate Developers: Obtain commitments for permanent financing after construction, providing certainty for project funding.
Comparing with Similar Financial Instruments
| Feature | Forward Commitment Agreement | Futures Contract | Option Contract |
|---|---|---|---|
| Binding Obligation | Yes, mandatory for both parties | Yes, mandatory for both parties | No, buyer has a choice |
| Customization | Highly customized, private contracts | Standardized, exchange-traded | Either standardized or customized |
| Trading Venue | Over-the-counter | Public exchanges | Exchanges and OTC |
Risks to Consider
While forward commitment agreements manage interest rate risk effectively, they introduce counterparty risk—the chance the other party fails to fulfill their obligation. Hence, they are generally executed between financially stable institutions.
For more details about the mortgage secondary market, see Secondary Mortgage Market.
Sources:
- Investopedia: Forward Commitment
- Federal Housing Finance Agency: Secondary Mortgage Market
- NerdWallet: Forward Contracts Explained