Point buying may not pay off

December 31, 2006|By Amy Hoak, MarketWatch

A recent report says borrowers tend to purchase too many points when selecting a mortgage--and end up paying more than they would 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 how long they will hold their loans. They tended to pay off their mortgages about 37.5 months too early for the purchase of points to pay off--defaulting, moving or refinancing before the point that the strategy made financial sense.

By purchasing points, borrowers lower the mortgage rate. One point is equal to 1 percent of the mortgage, charged as prepaid interest. Points 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, and we underestimate the possibility that we may have to move," Yavas said.

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

It's significant to mention, however, that the data cover 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 home a few years back and considered the trade-off between points and interest rates.

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