Do Not Pay Point to Reduce Mortgate Rate

I never pay point to reduce mortgage rate because it doesn't worth it. Here is what the expert says.

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. The study 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, but the study was done independently of her employer, and she speaks for herself and not on behalf of Freddie Mac. Yavas is an economist and a professor of business administration at Penn State and 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. By this rule of thumb, if you can borrow $200,000 at a rate of 6.25 percent with zero points, you can borrow the same amount at a rate of 6 percent by paying one point, or $2,000. In the above situation, you save $32.33 a month by paying one point. It takes 62 months to break even -- for the accumulated monthly savings to total the $2,000 paid upfront. 8-year study Chang and Yavas looked at a sample of 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 for the study. Of those people, 16 percent already had benefited from paying points by June 2005, and the percentage probably grew higher as time passed. That doesn't change the fact that two-thirds of the points payers made the wrong bet. Of the seven-eighths of the borrowers who did not pay discount points, a large majority 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.

Lenders weigh in
Bob Moulton, president of Long Island-based Americana Mortgage, says the results probably would have been different in a time of rising rates. He says a greater percentage of people would have held onto their mortgages past the break-even point if rates had been rising, instead of mostly falling, during the study period.

But even when rates are generally on the way up, they sometimes fall, at least briefly. "If you look at how interest rates fluctuate over time, a quarter of a percent is not unusual," says Steve Habetz, owner of Threshold Mortgage in Westport, Conn.

"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.

Bob Walters, chief economist for Livonia, Mich.-based Quicken Loans, notes that the researchers looked only at fixed-rate loans. He says the break-even period is shorter on adjustable-rate mortgages -- typically, one discount point reduces the interest rate by half a percentage point instead of one-quarter of a percentage point.

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.

Description, not prescription
Chang stresses that 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.

Woodheads and sunk costs
Chang and Yavas uncovered a disturbing tendency of borrowers to hang onto their mortgages too long if they had paid points. Too many consumers don't understand the concept of sunk costs.

A sunk cost is an expense that, once paid, should have no bearing on future spending decisions. When you pay discount points, you wave goodbye to your money. If rates plummet a couple of years later, and you would save money by refinancing, you should do it. That's the smart move financially, and it doesn't matter whether or not you paid points.

Human nature being what it is, we don't always do the financially optimal thing. We exhibit what's called "woodhead" behavior -- doing irrational things, such as refusing to refinance even when we would save a lot of money, just because we spent money on discount points.

"Instead of simply regretting the past and treating the point payments as a sunk cost, they may be delaying their refinancing decisions to make their point choices look better," the researchers write.

Chang says there might be other reasons for procrastinating -- not wanting to disclose financial information on a refinance application, not having time to apply, or "waiting for a deeper rate reduction, possibly for points paid previously that had not reaped its full return." All of these are hard to fit into economic models.

The nitty-gritty
Back to the original question: Should you pay discount points? Maybe, if paying points gives you peace of mind and you expect to keep the mortgage past the break-even point.

Just remember that Chang and Yavas say that most people overestimate how long they'll keep the mortgage. As Yavas explains, borrowers "simply have inaccurate or irrational expectations about future interest rates and their chances of moving to a different location (e.g., due to job relocation)."

Don't be a woodhead if you pay discount points and then rates drop enough to warrant refinancing. Go ahead and refinance. Accept the fact that you made the wrong bet by paying points -- you wagered that rates wouldn't fall far, and they did. That doesn't matter. What matters is that you can save money now.