As usual all the web sites are worthless and all the "real estate professionals" are morons, they just spout the bullshit that was in their training packet that says something about "points pay themselves off after N years so it depends on how long you will live there" ; great, thanks.
I tend to make mistakes on this stuff, so you can check me and let me know if I'm right in these calculations.
The big thing that everyone seems to fuck up is that there are two different factors changing the value of money :
1. inflation is making the mortgage payments actually cost less than they seem to, that is, later payments actually cost you much less in today's dollars, and
2. opportunity cost market appreciation is making points cost more than they seem to. That is, any dollar spent on points could go in the market and earn something (presumably slightly more than inflation).
Running these numbers :
30-year fixed rate loan 417k loan amount (maximum conforming loan) 4.50% base APR 0.125 APR per point points cost 1% of loan inflation 3% annual market appreciation 1.5% after inflation (same as APR) The total amount paid after 5,10,20,30 years , with 0.0-1.5 points : (in today's dollars)
| years | 5 | 10 | 20 | 30 |
| 0.0 | 117880.594414 | 219360.356317 | 381927.354991 | 502405.045225 |
| 0.5 | 119265.482032 | 220177.748517 | 381947.163920 | 501998.542376 |
| 1.0 | 120653.534938 | 221001.030904 | 381977.228228 | 501605.529932 |
| 1.5 | 122044.768524 | 221830.232121 | 382017.597785 | 501226.073492 |
The normal numbers that you see everywhere don't include inflation or appreciation and look something like this :
| years | 5 | 10 | 20 | 30 |
| 0.0 | 126772.664518 | 253545.329037 | 507090.658074 | 760635.987111 |
| 0.5 | 127930.215974 | 253775.431949 | 505465.863897 | 757156.295846 |
| 1.0 | 129091.171485 | 254012.342971 | 503854.685941 | 753697.028912 |
| 1.5 | 130255.547604 | 254256.095209 | 502257.190418 | 750258.285627 |
Which lead you to believe that points are actually a big savings after 15 years or whatever. In reality it seems to me that they hurt you up front and basically never make it back. (after 30 years they finally do, but the liquid investment has added utility which makes it still the winner)
As usual the exact right answer depends highly on the assumed figures, and there's huge uncertainty about them. However I think we can reliably say that points are grossly over-valued in the popular literature.
The next question is - if I have some extra cash, should I pay more down payment or put it in the market? (more down payment is equivalent to early prepayment, so this is equivalent to asking if you should early prepay).
Same assumptions as above. Extra cash available is 0.5-2.0% of loan amount Note : rows of this table are not directly comparable Blue columns : extra cash put towards reducing loan amount Black columns : extra cash saved and appreciated (counted as reduction of amount paid after N years)
| cash | 5 | 5 | 10 | 10 | 20 | 20 | 30 | 30 |
| 0.0 | 117880.594414 | 117880.594414 | 219360.356317 | 219360.356317 | 381927.354991 | 381927.354991 | 502405.045225 | 502405.045225 |
| 2085.0 | 117291.191442 | 115633.311216 | 218263.554536 | 216938.158824 | 380017.718216 | 379113.426599 | 499893.019999 | 499136.033092 |
| 4170.0 | 116701.788470 | 113386.028018 | 217166.752754 | 214515.961330 | 378108.081441 | 376299.498207 | 497380.994773 | 495867.020958 |
| 6255.0 | 116112.385498 | 111138.744819 | 216069.950972 | 212093.763837 | 376198.444666 | 373485.569815 | 494868.969547 | 492598.008825 |
| 8340.0 | 115522.982526 | 108891.461621 | 214973.149191 | 209671.566343 | 374288.807892 | 370671.641423 | 492356.944321 | 489328.996691 |
Keeping the cash in the market is better over all time scales.
What if the market only matches inflation and doesn't beat it by that 1.5% ?
| X | 5 | 5 | 10 | 10 | 20 | 20 | 30 | 30 |
| 0.0 | 117880.594414 | 117880.594414 | 219360.356317 | 219360.356317 | 381927.354991 | 381927.354991 | 502405.045225 | 502405.045225 |
| 2085.0 | 117291.191442 | 115795.594414 | 218263.554536 | 217275.356317 | 380017.718216 | 379842.354991 | 499893.019999 | 500320.045225 |
| 4170.0 | 116701.788470 | 113710.594414 | 217166.752754 | 215190.356317 | 378108.081441 | 377757.354991 | 497380.994773 | 498235.045225 |
| 6255.0 | 116112.385498 | 111625.594414 | 216069.950972 | 213105.356317 | 376198.444666 | 375672.354991 | 494868.969547 | 496150.045225 |
| 8340.0 | 115522.982526 | 109540.594414 | 214973.149191 | 211020.356317 | 374288.807892 | 373587.354991 | 492356.944321 | 494065.045225 |
Now over 30 years paying off the loan early is better. But again it's so minor that if you count the utility of liquidity it just never makes sense.
One exception to all this would be if the market actually inverts for a while (returns less than inflation, or negative inflation-adjusted). It seems to me that is a real valid concern over the next 10-20 years, but when that happens pretty much all the "common wisdom" goes out the window.
6 comments:
it feels like you are undervaluing risk in your market assessment. Especially in the near term, you aren't going to find anywhere to put your money that makes better than 1% and has the liquidity you consider a boon. And the inflation affects your investment money as well...
Agree with soal that you're undervaluing risk in your assessment, but properly valuing risk and volatility is a much more complicated equation. Also, 3% average inflation feels very much like an overestimate--_especially_ over a shorter loan term.
At the end of the day, the people who set mortgage rates are generally intelligent professionals who do these types of analyses day-in and day-out. In normal times at least (which is basically what you've modeled here), they make money hand over fist by doing things exactly like valuing risk and estimating inflation. A person thinking they'll outsmart mortgage lenders with a few back-of-the-envelope calculations is the same as a day trader thinking he'll outsmart the army of quants and analysts at any number of hedge funds and high end trading firms.
That being said, I totally agree with you that points don't make sense for 95% of borrowers. Like you say, the majority of people are completely cluess about how inflation affects the time-value of money. But more importantly, as you point out, most people dramatically underestimate the value of liquidity.
There's also the whole issue of minimizing your upfront cost to avoid tying up too much of your money in a single asset, but if you're in a recourse state, that argument doesn't really apply since you're really on the hook for the whole sale price the minute you close on the house.
"Agree with soal that you're undervaluing risk in your assessment"
I thought it was inherently obvious that the option of putting money in the market has more risk than paying off your mortgage. I'm not sure why I need to say anything more about that because quantifying it is impossible at this level of analysis.
"A person thinking they'll outsmart mortgage lenders"
Well, this is complicated. Obviously the people at the big agencies who actually set the funds rate are smart and are doing complicated analysis to ensure that they make the right amount of profit blah blah blah.
Of course we're not trying to outsmart them.
Your actual mortgage broker who is giving you advice on whether to take points or not - absolutely you can outsmart them with a few scribbles.
You might ask yourself - why do they even give you the option of taking points?
So far as I can tell, it's a trick to sucker money of you. Basically they've cooked it up (with all their analysis and smarts) so that they expect you to lose money on it, but they can explain it in a way that it's not totally obvious that you do lose money on it.
Furthermore, I suspect most people who get points these days aren't even aware of it. I see a lot of the discount lenders offering really low APR's (4.250 for example) in big banner ads, and then only if you look at the fine print you see the way they got that was with points.
Also the whole idea that "it's complicated, trust the experts" is absurd and I reject it categorically.
Obviously the insurance adjusters that set the rates at the big companies are carefully evaluating risk and expected costs far better than I ever could. That doesn't mean that you should just take whatever they offer you, because they are specifically calculating the rates that will fuck you over while making it seem not too bad.
"That doesn't mean that you should just take whatever they offer you, because they are specifically calculating the rates that will fuck you over"
I agree with this 100%--sorry if I implied otherwise. Doing some analysis yourself is super important to make sure you're not getting bent over, and your analysis looks good. I acutally think it's both interesting and unsurprising that a semi-careful analysis basically makes points look like a wash over various loan terms and time frames once inflation is taken into account. This is more-or-less what I would expect the mortgage lenders to be doing on their side. (And I also would be expecting mortgage brokers to be slipping in extra points on their own any chance they can :)
Yeah I'm sure the financiers price them specifically to be a wash, and then just crank up the price slightly so that you are hurt in the short run, and then they count on many mortgages being held for short periods to make some extra profit.
BTW a common error on lots of web sites is that "points cost 1% of loan amount". That's not actually true - if it was true then you could find scenarios where points actually were a big win. In reality, the price of points floats, and I'm sure it floats specifically to match investments,inflation,etc.
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