1 Mortgage Mistake Millions of Americans Make

Source: Flickr / Mark Moz.

Buying beyond our means, adjustable rate mortgages, and reverse mortgages are common mortgage mistakes that many consumers make. But even financially savvy Americans can make the wrong choice when it comes to paying mortgage discount points. The decision on whether or not to pay points is not necessarily as simple as many mortgage originators would have homebuyers believe.

In a perfect world...
In general, each mortgage discount point paid at a price of 1% of the mortgage loan reduces the mortgage interest rate by 0.25%. Over the course of a 30-year mortgage, this can amount to a huge overall savings.

Using a sample mortgage of $250,000 with a 5% mortgage loan interest rate, (without any points paid) the total interest paid over the life of the loan amounts to $233,139. The same mortgage loan with one point paid (for a cost of $2,500) has interest that amounts to $219,483. In other words, the $2,500 investment toward reducing mortgage loan interest resulted in a savings of $13,656, which minus the original investment amounts to $11,156. A no-brainer? Let's do the math.

The reality of the situation
The interest savings realized each month in the above mortgage situation with one point paid totals $37.93, meaning that it would take about 66 months, 5.5 years, to make back the initial $2,500 investment. The simplest (and somewhat flawed) assumption homeowners make is that if they plan to keep the same mortgage for at least the 5.5 year threshold, then paying points is a good investment.

In what seems like a feel-good gesture, the nation's largest mortgage originators like Wells Fargo (NYSE: WFC  ) and JPMorgan Chase (NYSE: JPM  ) provide homebuyers the option to pay points and in some cases even finance points as part of their mortgage amount. Here are a few reasons why the true payback may not be as grand as the math implies.

Source: Flickr / Mark Moz.

The first consideration is whether the homeowner has 1% of the home's value to pay points on the mortgage loan. If this money is tough to get and could result in other higher-interest loans, the decision not to pay points is fairly obvious. But let's assume the homeowner has an additional $2,500 available.

The biggest issue to consider is the opportunity cost of the $2,500 invested to pay down the mortgage loan interest rate. Consider two reasonable alternatives to how the same money may be spent. Option one would be to use the $2,500 as an additional down payment on the loan, option two would be to invest the $2,500 and yield a conservative 5% rate of return.

Using the $2,500 as an additional down payment would lower the monthly mortgage payment by $13.42, and extending the breakeven point from 5.5 years to 102 months, or 8.5 years. Beyond 8.5 years, paying points still may be the better investment, but homeowners unsure of how long they may reside in the home may be better off putting the money toward their down payment and gaining an immediate return on their investment.

Though small, the contribution toward reaching a 20% downpayment would also hypothetically lead to a quicker removal of the required Private Mortgage Insurance or PMI that lenders automatically place on mortgage loans in excess of 80% of the home's value.

Option two had the homeowner investing the $2,500 with an expected 5% yield. Over the 30-year life of the loan, the original investment would be worth $11,170, compared with the $13,656 saved in interest.

If the investment can yield 5.68% compounded monthly, the future value of the investment roughly equates to the interest savings from paying points. If the homeowner can earn a still reasonable 8% rate of return, that investment would be worth twice as much as the amount of interest saved by paying points.

Making the right choice
The break-even point cited by mortgage originators is a guideline at best, and makes the assumption that you can afford 1% of your mortgage loan amount and second, that you would otherwise not invest it wisely. While I hope the first condition is something you can meet, I hope the second is not. Ultimately, the right choice depends on your circumstances. 

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Read/Post Comments (6) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 07, 2014, at 12:48 PM, pelo1 wrote:

    "Buying beyond our means, adjustable rate mortgages, and reverse mortgages are common mortgage mistakes that many consumers make."

    The first "mistake" is the only actual mistake. The author has no idea what would constitute a mistake or a strategy or even a necessity when it comes to the other 2.

    Paying points makes sense in very few circumstances. There are now 3,5,7,10 and even 15 year ARM's so don't tell me it's a mistake to get a half point lower on a rate for a decade or 15years straight.

    Motley Fool, drop this clown asap. he must work part time for Chase or Wells since they have crappy ARM rates and no reverse mortgage dept's anymore.

  • Report this Comment On June 07, 2014, at 1:53 PM, grandmafufu wrote:

    Biggest mistake? Well, actually there are a few. 1. buying more house than you need just because you qualify for a mortgage to buy that thouse; 2. assuming that because you can afford the mortgage payment, that you can afford to buy a house, of any kind. 3. not having enough in your savings account to pay your mortgage/tax/HO for at least 6 months in case of emergencies. 4. buying based on "location, location, location:--the only thing about the location should be the schools, crime rate, access to hospitals/doctors and weather. A "view to die for" is just that------and your mortgage will die a horrible death. 5. not doing a full home inspection-----never ever take the sellers and/or the RE agents word for anything----they have agendas that are not compatible with yours, period. No gray areas here, even if the agent is your best friend!!! 6. putting down too much and then not having enough to pay moving costs which can be costly. 7. having enough money to pay your first few months of utility bills until you see just how high/low they will run (actually you can get all that info from the seller and/or the utility companies serving that house. That's a few of them; actually there are more. But, why should I give away all my secrets???

  • Report this Comment On June 07, 2014, at 4:04 PM, ibarz wrote:

    Rule of thumb is typically, if the return for points you pay is 3 years or less, then pay the points.

    The biggest mistake everyone makes is always not looking at the rent/buy ratio. I'm talking about people than CAN buy a house, those who has the option of either buying or renting.

  • Report this Comment On June 08, 2014, at 3:11 AM, greyhound44 wrote:

    Paid off my last debt - a 15 year residential mortgage

    4 years early in 1991, Sold that house of nearly 25 years in 2004. Lots of untaxed capital gain there.

    Paid cash for my next two in 2003 and 2005. Sold the 2003 house for a nice net US$ 86K untaxed capital gain after 25 months

    I would never deal with any Bank lender again!!

    They ALL SUCK!!

    retired expatriate (11 years) MD: NBME; ABIM; ABNM; ABR w/spec comp NR

  • Report this Comment On June 08, 2014, at 12:40 PM, jonhennemann wrote:

    This calculation is so far off. You have to consider if you paid 2,500 with your first payment you would lower your principal by 2,500 and not pay interest on that amount over the life of the loan (around 11K), plus if you sold the house on year 7 you would have use of all the 2,500 rather then a lower interest you will use over 30 years. Really most home loans last 7 years so you should look at the 7 year cost and return, not the 30 year!

  • Report this Comment On June 08, 2014, at 9:04 PM, kcoop32 wrote:

    your biggest mistake is NOT to go with wells fargo, they bought my mortgage and they have done nothing but lie to me over and over

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