Academic journal article Real Estate Economics

Mortgage Choice: What's the Point?

Academic journal article Real Estate Economics

Mortgage Choice: What's the Point?

Article excerpt

One of the most striking features of the mortgage market in the United States is the wide variety of loans available to potential borrowers. Not only are there different types of loan (e.g., fixed vs. adjustable rate), but even within any single type there are loans with many different combinations of interest rate and points. As an illustration of the extent of the selection available, Table 1 shows a sample of fixed rate mortgages (FRMs) available on February 13, 1996 from a single representative U.S. mortgage lender. Furthermore, recent empirical findings show that, for a given coupon rate, mortgages with low points tend to be prepaid more rapidly than mortgages with high points (see Brueckner 1994 and Hayre and Rajan 1995), suggesting that differences among the behavioral characteristics of borrowers may be associated with the interest rate/points trade-off. The empirical evidence in favor of this relationship is so strong that many of the new-generation prepayment models on Wall Street have been redesigned to account for the effect of origination points on the speed of prepayment (see, for example, Hayre and Rajan 1995).

Table 1 Loans available, February 1996.

                                  Points (%)      Points (%)
Loan Life    Interest Rate (%)    (Conforming)    (Jumbo)

30-Year            6.750             1.470
                   6.875             1.360
                   7.000             0.870
                   7.125             0.380
                   7.250            -0.110          1.920
                   7.375            -0.600          1.295
                   7.500            -1.090          0.795
                   7.625            -1.500          0.325
                   7.750            -1.920         -0.145
                   7.875            -2.330         -0.520
                   8.000                           -0.830
                   8.125                           -1.150
                   8.250                           -1.365

15-Year            6.250             1.470
                   6.750            -0.010          1.875
                   6.875            -0.410          1.500
                   7.000            -0.820          1.185
                   7.125            -1.140          0.845
                   7.250            -1.460          0.500
                   7.375            -1.780          0.250
                   7.500            -2.100          0.030
                   7.625                           -0.220
                   7.750                           -0.440
                   7.875                           -0.625
                   8.000                           -0.815
                   8.125                           -1.000

A selection of the loans available from a representative U.S.
mortgage lender, February 13, 1996.

Several explanations have been proposed for the existence of points. Dunn and McConnell (1981b) suggest that points serve to pay for the prepayment option embedded in fixed rate mortgages, although they do not explain why this payment should be made in the form of points, rather than via a higher coupon rate. Moreover, this story does not explain why we should see large menus of loans with different combinations of rates and points. Kau and Keenan (1987) suggest tax reasons for the existence of points, and one could imagine an extension of their story, in which diverse tax situations lead to a menu of different point/rate combinations. However, if this were the explanation, we should expect the relationship between points and mobility to be the opposite of what is observed, since high tax rate individuals, who have the greatest desire to deduct points up front, also tend to be the most mobile (see, for example, Borjas, Bronars and Trejo 1992). Moreover, despite the significant difference in the tax treatment of points on a first loan versus a refinance,(1) we see no difference between the sets of contracts offered to new borrowers versus refinancers. …

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