Paying mortgage points a smart investment
Returns are 'astonishing,' so why don't more borrowers take advantage?
Monday, February 05, 2007
By Jack Guttentag
Inman News
"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 Yan
Chang, senior economist at Freddie Mac, and Abdullah Yavas, research director
of the Institute for Real Estate Studies at Penn State's Smeal College of
Business, 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 from 1996-2003. But almost two-thirds 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 seven years was only 8 percent on a 30-year FRM,
on a 7-year ARM it was 22 percent. On a 3-year ARM, the return over three years
was 17.5 percent. I found this so astonishing that 10 days later I looked again
to be sure I hadn't made a mistake. Sure enough, I hadn't.
Do most
borrowers pass up this opportunity?
They do.
In the sample selected by Chang and Yavas, less than 15 percent 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 online 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. Using calculator 11c or 11d on my Web site, enter the two rate/point
combinations and the period you expect to be in your house. Presto, you have
the rate of return.
The
writer is professor of finance emeritus at the Wharton School of the University
of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
***
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Copyright 2007 Jack Guttentag
