Homebuyers face a million decisions about which mortgage to choose, which house to buy, and which room covered with 1970s wood paneling to redecorate first. Among those questions is the quandary over whether to pay discount points to lower the interest rate on a mortgage.
A recent paper says many borrowers don't hold their mortgages long enough to benefit from the strategy of prepaying mortgage points. By paying too many points up front, they end up paying more than if they had paid no points on a loan with a higher interest rate.
The study, written by Abdullah Yavas, the Elliott Professor of Business Administration at Penn State's Smeal College of Business, and Yan Chang of Freddie Mac, found that people tend to overestimate the time they'll hold their loans, according to The Associated Press.
The research found many people were no longer paying their mortgages -- because of default, refinancing, or moving -- before breaking even and benefiting from the strategy of prepaying points. On average, they paid off their mortgages more than three years too early.
With mortgage rates falling to historic lows during the time frame of the study (1996 to 2003), it may be that many homeowners thought the opportunity to refinance at a rock-bottom rate was just too good to pass up, whether their points strategy had paid off or not.
If you're shopping for a new loan or thinking about refinancing your mortgage, you'll want to consider a couple of factors before you choose a loan with discount points.
Discount points are prepaid interest that you pay at closing. They are charged to lower your mortgage interest rate, which lowers your monthly payments. If you give the bank more money up front, you pay them less over time.
A point, by the way, is 1% of the loan amount. If you're taking a mortgage for $200,000, one point is $2,000.
A general rule of thumb that you'll find (with lots of other useful information) in the Home Center is that it generally takes about five years to make up the additional point or points paid. After that, you'll be saving money on your mortgage.
So if you know you're planning to move in a few years, paying points may not be the best strategy. On the other hand, if you plan to pay every dime of a 30-year mortgage and never move, points could probably be to your advantage.
In some cases, you'll need to do a little math. That may be true if you're thinking about refinancing your mortgage, or if you're shopping around and trying to compare loans. In both cases, you'll want to figure out how long it will take to benefit from paying a point or points up front.
You can spend hours trying to run these numbers yourself, or you can head to The Motley Fool's online number cruncher. Look for the one under the "Home" banner titled "Should I pay points to lower the rate?" The results will tell you how long you have to own the home to break even on the refinancing.
Then, when you've settled this question, you can tackle the list of painting and repair projects.
For more pointers on points and other mortgage issues, peruse these articles:
Foolanthropy is celebrating its 10th year! To learn more about our five Foolish charities or to make a donation, visit www.foolanthropy.com.
Fool contributor Mary Dalrymple welcomes your feedback.