07-19-11 - Should I take points on my mortgage-

I'm pretty sure the answer is "no".

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.


soal said...

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...

mimi igs said...

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.

cbloom said...

"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.

cbloom said...

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.

mimi igs said...

"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 :)

cbloom said...

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.

old rants