EXTRA POINTS

Paying mortgage points rarely pays off for borrowers: study

CHICAGO (MarketWatch) -- A new report claims that borrowers tend to purchase too many points when selecting a mortgage -- and in the process end up paying more than they would have with no points and a higher interest rate.
The study was co-authored by Abdullah Yavas, Elliott Professor of Business Administration at Penn State's Smeal College of Business, and Yan Chang of Freddie Mac. The two considered 3,785 individual mortgages originated from 1996 to 2003, looking at the points paid, interest rates and loan length.

Data showed that, on average, those who buy points are overestimating the amount of time they will hold their loans. They tended to pay off their mortgages about 37.5 months too early for the purchase of points to actually pay off -- defaulting, moving or refinancing before hitting a break-even point so the strategy made financial sense.

By purchasing points, borrowers lower the interest rate on the mortgage. One point is equal to 1% of the mortgage, charged as prepaid interest. Points that you pay to purchase your primary residence are deductible in the year you pay them on your federal income-tax return; points you pay to refinance must be written off over the life of your mortgage.

"We underestimate the possibility that we may refinance in the near future -- or refinance again in the near future -- and we underestimate the possibility that we may have to move, either for job relocation or other reasons," Yavas said.

Only 1.4% of borrowers who purchased points held their loans long enough to make it pay off; of those who didn't buy points, only 1.5% would have been better off purchasing them, according to the study.

It's significant to mention, however, that the data covers a time of decreasing interest rates and increasing property values, which led to a lot of refinancing activity, Yavas pointed out.

The report also found that borrowers who buy points often don't treat them as costs they can never recover and so are less likely to refinance. When they do refinance, they often do it late, perhaps hoping to compensate for the points paid. If a borrower "paid too many points and the interest rates come down quickly, refinancing right away would be the same as accepting the fact that you shouldn't have paid those points," Yavas said.

Yavas took an interest in the topic after he decided to refinance his own home a few years back and considered the trade-off between points and interest rates.

"Although I teach this stuff, it's not a trivial question," he said.

Dec 20, 2006

By Amy Hoak

Marketwatch