I read recently about a study that says that
most people would not profit by paying points on a mortgage. Do you agree with
that?
No. The much-cited study by Chang and Yavas
claims that most borrowers don’t hold their mortgages long enough to make paying
points a good investment. The study based its conclusion on the life of
fixed-rate mortgages (FRMs) that were originated and terminated during the
period 1996-2003. But almost 2/3 of the loans in their sample were still in
existence at the end of the period, and they are bound to have a longer life
than those that were paid off. Further, the study did not cover adjustable rate
mortgages (ARMs), which in today’s market provide the most attractive
opportunities for paying points.
Even if the study was right, what "most people"
would profit from is beside the point. What matters is whether you would
profit from it.
Well, then, how do I know whether or not it
makes sense for me to pay points?
Points are an investment on which the return
consists of lower mortgage payments in the future, and a lower loan balance if
the loan is paid off before term, which almost all are. The investment makes
sense for borrowers who have the money and find the return high enough to be
attractive.
The standard view is that the borrower’s time
horizon must be quite long to make points worthwhile -- I have made this
statement myself many times. However, when I recently calculated rates of return
for different types of mortgages, I found that the standard view holds only for
FRMs. On ARMs, the returns are high over periods equal to the initial rate
period.
For example, while the return over 7 years was
only 8% on a 30-year FRM, on a 7-year ARM it was 22%. On a 3-year ARM, the
return over 3 years was 17.5%. I found this so astonishing that 10 days later I
looked again to be sure I hadn’t made a mistake; I hadn’t. The complete results
are shown in the table at the bottom.
Do most borrowers pass up this opportunity?
They do. In the sample selected by Chang and
Yavas, less than 15% paid points. Borrowers are predisposed against an increase
in their cash outlays at closing for a benefit that will accrue in the future.
Nobody tells them what the rate of return on investment might be. Often, they
aren’t even offered the option.
Mortgage brokers and loan officers don’t
encourage borrowers to pay points. Points make it more difficult for loan
officers working for lenders to earn an "overage" – a price above the lender’s
stated price, which the loan officer usually shares with the lender.
Similarly, if borrowers pay points for a lower
rate, mortgage brokers are forced to disclose their own fees upfront where
borrowers can see and possibly question them. The broker can’t avoid disclosure
when his fee must be added to the points. It is much better to steer the
borrower to a loan with a rate high enough that the lender will pay points to
get it, referred to as a "yield spread premium", or YSP. Then the broker can pay
himself out of the YSP, which existing rules permit to be disclosed in ways that
usually mean nothing to the borrower.
How can borrowers be sure that the option to pay
points will be made available to them?
One of the advantages of shopping for a mortgage
on-line is that the alternative rate/point combinations appear on the screen.
The rates of return shown above were calculated from data shown by one such
lender, Amerisave, an
Upfront Mortgage Lender.
Upfront Mortgage Brokers will
also provide the required data. Since their fee is set upfront, they have no
financial interest in which rate/point combination the borrower selects.
How do I find the rate of return?
You need two price quotes for the loan type you
want. One is the rate/point combination with points closest to zero. The other
is the combination for the lowest rate available. Use calculator 11c,
Mortgage Points Calculator: Rate of Return on FRMs, or 11d,
Mortgage Points Calculator: Rate of Return on ARMs.
Enter the two rate/point combinations and the period you expect to be in your
house. Presto, you have the rate of return.
Annual Rate of Return on Investment in Points, by Type of Mortgage and Holding
Period, December 28, 2006