Pipeline risk represents a critical challenge for mortgage lenders during the interval between a borrower locking in a mortgage interest rate and the final closing and sale of the loan. This period exposes lenders to two primary risks: interest rate risk and fallout risk.
Interest rate risk occurs because when a borrower locks in a rate, the lender promises that rate regardless of market changes. If rates rise before closing, the lender may have to sell the loan at a discount to investors, incurring a loss because the locked rate is less favorable than current market rates. Conversely, if rates fall, borrowers might abandon their current application (“fallout”) to secure a better deal elsewhere, causing lenders to waste processing resources.
For example, if a borrower locks in a 6.75% rate and rates rise to 7.25% before closing, the lender loses value on that loan. If rates fall to 6.25%, the borrower may cancel, resulting in lost underwriting costs for the lender.
Lenders manage pipeline risk through hedging strategies involving financial instruments designed to offset potential losses from fluctuating interest rates. This risk management process is complex and its costs are factored into mortgage interest rates and fees.
Understanding pipeline risk helps borrowers appreciate why mortgage rates and fees can vary and why lock-in terms are structured as they are. For more detail on locking mortgage rates, readers can visit our glossary entries on Interest Rate Lock and Extended Rate Lock.
Additionally, hedging techniques lenders use are further explained in our article on Forward Rate Agreement (Loan Hedge).
Pipeline risk differs from other types of risks in lending due to the unique nature of secondary mortgage markets, where loans are quickly sold after origination to investors like Fannie Mae or Freddie Mac. This makes the lender’s commitment during the pipeline period particularly sensitive to rate movements and borrower decisions, a risk less common in shorter-term loans such as auto or personal loans.
For authoritative information on mortgage rate locks and pipeline risk, visit the Consumer Financial Protection Bureau’s resource on mortgage rate locks.
By understanding pipeline risk, borrowers gain insight into why lenders set certain fees and terms and how fluctuations in interest rates can influence the home loan process.
