Most borrowers who paid points to lower their mortgage rates at a time when interest rates were falling and property values were rising came out behind, and were less likely to take advantage of opportunities to refinance their loans, a new study concludes. 

For mortgages originated between 1996 and 2003, less than 2 percent of home buyers held their loans long enough to justify buying points, according to the study, “Do Borrowers Make Rational Choices on Points and Refinancing?

The study’s authors, Abdullah Yavas, research director of the Institute for Real Estate Studies at Penn State’s Smeal College of Business, and Yan Chang, senior economist at Freddie Mac, analyzed 3,785 mortgage loans.

Yavas and Chang wanted to know if borrowers make smart decisions about whether to purchase points or pay higher interest rates. The study found that nearly everyone who bought points during the period studied would have been better off paying higher interest rates, and that those who decided to pay higher interest rates instead of purchasing points almost always made the right decision.

Most fixed-rate mortgages allow borrowers to pay an upfront fee, or points, in exchange for a more favorable mortgage rate. The study, found that, on average, buyers who purchased points ended up defaulting, moving or refinancing more than three years before reaching the break-even point from purchasing points.

Only 1.4 percent of borrowers who purchased points during the period studied held their loans long enough to make the decision to buy points pay off, the study found. The study also concluded that of those borrowers who did not buy points, only 1.5 percent would have been better off doing so.

Although the study indicates that borrowers who purchased points overestimated how long they would hold their mortgages, the period studied was marked by historically low mortgage rates and rising property values — conditions that make refinancing advantageous. The study’s findings are partially attributable to the fact that borrowers could not have foreseen the rapid decrease in interest rates, the authors said.

“An obvious extension of the current study would be to apply it to a period of increasing interest rates and/or decreasing property values,” the authors noted.

The study was conservative, however, in accepting the “conventional wisdom” that each point purchased reduces the interest rate of the loan by 0.25 percent. The study found that in practice, the interest-rate reduction is likely to be less, but used the 25-basis-point assumption in calculating how long a loan needed to be held for a borrower to benefit.

Purchasing points also seems to make borrowers less receptive to opportunities to save money by refinancing, the study found. Yavas and Chang theorize that some borrowers aren’t as open to the idea of refinancing because they don’t want to admit they were wrong to purchase points, and are unable to see them as “sunk costs.”

“Although the economic theory states it very clearly that only marginal cost and benefits are relevant and previously incurred sunk costs should be irrelevant, our results indicate that sunk costs do matter in refinancing decisions of borrowers,” the authors said. “One explanation for this behavior is that borrowers dislike admitting that they would be better off had they made different points choices. Instead of simply regretting the past, they may be delaying their refinancing decisions to make their point choices look better.”

The study may prove useful not only to borrowers, but to lenders, who view points as insurance against a borrower closing out a loan sooner than expected. Borrowers who expect to move, the thinking goes, won’t pay points. But the study found that points don’t affect whether a loan will go into default or whether the borrower will move and close out a loan — perhaps because such events are often triggered by circumstances outside of the borrowers’ control.

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