Is It True That Paying Mortgage Points Doesn't Pay?

January 22, 2007, Revised April 10, 2011

"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 Chang and Yavas 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 1996-2003. But almost 2/3 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 cash 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 7 years was only 8% on a 30-year FRM, on a 7-year ARM it was 22%. On a 3-year ARM, the return over 3 years was 17.5%. I found this so astonishing that 10 days later I looked again to be sure I hadn’t made a mistake; I hadn’t. The complete results are shown in the table at the bottom.

Do Most Borrowers Pass Up This Opportunity?

They do. In the sample selected by Chang and Yavas, less than 15% 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. See What Is a Mortgage Overage? 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.

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 on-line is that the alternative rate/point combinations appear on the screen. The rates of return shown below 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. Use calculator 11c, Mortgage Points Calculator: Rate of Return on FRMs, or 11d, Mortgage Points Calculator: Rate of Return on ARMs. Enter the two rate/point combinations and the period you expect to be in your house. Presto, you have the rate of return.

Annual Rate of Return on Investment in Points,
by Type of Mortgage and Holding Period, December 28, 2006

Mortgage Program 40-Year FRM 30-Year FRM 15-Year FRM 10-Year FRM 7/1 ARM 5/1 ARM 3/1 ARM
High Rate/Low Points  5.875%
.51 pts
0 pts
0 pts
0 pts
.33 pts
.27 pts
.46 pts
Low Rate/High Points  5.25%
4.08 pts
3.76 pts
2.41 pts
3.19 pts
1.84 pts
2.00 pts
2.89 pts
  Rate of Return on Investment in Points
Over 3 Years -32.2% -25.1% -13.9% -13.7% -0.4% -7.4% 17.5%
Over 4 Years -13.8% -8.7% -0.9% -1.7% 11.5% 5.6% 26.3%
Over 5 Years -4.1% -0.2% 5.5% 4.1% 17.2% 12.0% 25.0%
Over 6 Years 1.6% 4.8% 9.0% 7.1% 20.3% 11.8% 24.1%
Over 7 Years 5.3% 7.8% 11.1% 8.8% 22.0% 11.5% 23.4%
Over 8 Years 7.7% 9.9% 12.4% 9.7% 21.5% 11.3% 22.8%
Over 9 Years 9.4% 11.2% 13.2% 10.2% 20.1% 11.2% 22.4%
Over 10 Years 10.6% 12.2% 13.7% 10.3% 20.8% 11.1% 22.1%
Over 15 Years 10.6% 14.2% 14.3%   20.0% 10.7% 22.2%
Over 30 Years 14.3% 14.7%     19.7% 10.4% 22.9%

Notes: Price quotes are from as of December 28, 2006. The loan amount is $320,000 secured by a $400,000 single-family property purchased for permanent occupancy in California by a borrower in the 27% tax bracket with excellent credit who provides full documentation. On all the ARMs the margin is 2.25% and the current index value is 5.314%. Caps on the first rate adjustment are 5% on the 5/1 and 7/1, and 2% on the 3/1. Subsequent adjustment caps are 2% in all cases. Rates of return on the ARMs assume the index value does not change. The “high-rate” is the rate closest to zero points. The “low-rate” is the lowest rate quoted.

Postscript: When I checked these rates of return on April 10, 2011, they were a little smaller than in December 2006, but not by much.

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