Pay discount points on a mortgage, and you take a gamble. Plenty of borrowers lost that wager in recent years, according to a pair of economists.Yan Chang and Abdullah Yavas set out to describe consumers’ behavior, not to give advice about whether one should pay discount points. Even so, their research can be boiled down to this: Think hard before you pay discount points, and if you do, don’t hesitate to refinance.
Their research paper, titled, “Do Borrowers Make Rational Choices on Points and Refinancing?” is a chapter of Chang’s doctoral thesis at Penn State University. Chang is a senior economist at mortgage-financing giant Freddie Mac. The study was done independently of her employer, and she speaks for herself. Yavas, an economist and professor of business administration at Penn State, was her thesis adviser.
Chang and Yavas concluded that borrowers tend to pay too many points because they overestimate how long they’ll keep the mortgage. Furthermore, people who pay discount points tend to wait too long to refinance.
Paying discount points is a way of reducing the mortgage’s interest rate. One discount point is 1 percent of the loan amount. On a 30-year, fixed-rate mortgage, one point typically reduces the rate by one-quarter of 1 percent. If you can borrow $200,000 at 6.25 percent with zero points, you could borrow the same amount at 6 percent by paying one point, or $2,000. That would save $32.33 a month. It would take 62 months to break even _ for the accumulated monthly savings to total the $2,000 paid upfront.
Chang and Yavas looked at 3,899 mortgages that were originated between January 1996 and December 2003. About one-eighth of those borrowers paid discount points.
Of those who paid points:
_ Two-thirds had paid off the mortgage by June 2005, either because they sold the house, refinanced or defaulted on the loan. Of those people, 1.4 percent had benefited by paying points.
_ The other one-third of the points payers still had the original mortgage in June 2005, the cutoff date. Of those people, 16 percent already had benefited from paying points by June 2005, and the percentage probably grew higher as time passed.
To summarize: At least two-thirds of the points payers made the wrong bet. Most of the non-points payers made the right call.
That might sound like a slam-dunk case against paying points. It’s not, because mortgage rates were falling and home values were rising during much of the study period, creating many opportunities to refinance.
“Personally, I think that it is a caveat of this study that it covers a period typified by historically low mortgage rates and increasing house prices, which offers borrowers more incentive to refinance than times of rising interest rates, where more borrowers might reap the full benefits of mortgage points,” Chang says in an e-mail interview.
Would the result have been different in a period of rising rates? “That we simply do not know,” Yavas says in an e-mail interview while on sabbatical in Turkey.
Bob Moulton, president of Long Island-based Americana Mortgage, says the results probably would have been different in a time of rising rates because a greater percentage of people would have held onto their mortgages past the break-even point.
Steve Habetz, owner of Threshold Mortgage in Westport, Conn., argues that even when rates are generally on the way up, they sometimes fall briefly. “Take a look at any graph of interest rates for any four-year period, and unless you’re a market-timing genius, you’re not going to benefit by paying points,” Habetz says.
Bill Lyons, president of San Diego-based LEI Financial, says a lot of people would benefit from making an extra payment every year rather than paying discount points.
Chang says she’s describing how people act, not prescribing what they should do. She says her paper makes the point that “the decision process of the borrowers is more complicated than our model can capture.”
“What we could measure,” she adds, “and what the economic theories use as the basis of analysis, are the monetary incentives _ gains or losses in dollar terms _ but what we can’t observe are the hidden motives: Some borrowers may consider time spent entertaining their families is more valuable than watching the rise and fall of the rates, and therefore choose to pay points because they wish to lock in on a low rate so they don’t have to spend time watching out for refi opportunities.”
Bottom line: “Borrowers make the choice based on their own needs and expectations, and in many cases paying points works in their favor.” Even if that can’t be measured solely in dollars and cents.
The benchmark 30-year fixed-rate mortgage rose 10 basis points, to 6.42 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week’s survey had an average total of 0.34 discount and origination points. One year ago, the mortgage index was 6.28 percent; four weeks ago, it was 6.24 percent.
The 15-year fixed-rate mortgage rose 12 basis points, to 6.19 percent. The 5/1 adjustable-rate mortgage rose 9 basis points, to 6.3 percent