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40 years!?

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Did you hear the news? The Federal Housing Administration has approved offering 40 year mortgages.

Is this a good or bad thing? Well, that depends on who you ask. As with most things, there are differing opinions on the 40 year mortgage.

Before we dive into that, let's recap some mortgage basics first.

Your monthly mortgage payment amount is determined by 3 main factors:

  • the amount of the mortgage

  • the interest rate

  • the term of the mortgage (the length of time)

Mortgages have typically been a term of 15 or 30 years.

Mortgages are either fixed rate or variable rate. Fixed rate is the same rate for the life of the mortgage and variable is when the rate changes, usually based on market interest rates. It may have a fixed rate for a few years and then the variable kicks in.

Mortgages generally require a down payment with 20% being the standard. If you do a lower down payment then you will most likely have to pay PMI (private mortgage insurance).

Mortgages are amortized. This means that at the beginning of the mortgage, the majority of the payment is going towards interest not principal. As you get further into the term of the mortgage the amount towards principal increases and the amount towards interest decreases.

So, what are the pros and cons of the shorter term versus the longer term?

Pros of a shorter term, such as a 15 year fixed-rate mortgage:

  • lower total interest paid over the life of the mortgage

  • builds equity quicker

  • generally have a lower interest rate than the longer 30 year option

  • and the obvious, the mortgage is paid off quicker

Cons of a shorter term, such as a 15 year fixed-rate mortgage:

  • higher monthly payment

  • usually results in the purchase of a less expensive home than the 30 year option meaning you may be giving up location, space, amenities, etc

The pros and cons of the longer option, such as the 30 year or even 40 year, are basically the opposite of the shorter term.

Pros of a longer term, such as a 30 year fixed-rate mortgage:

  • lower monthly payment

  • usually allows you to purchase a more expensive home

Cons of a longer term, such as a 30 year fixed-rate mortgage:

  • more interest paid over the life of the mortgage

  • slower growth in equity

  • generally have a higher interest rate than the shorter 15 year option

Extending the loan term out to 40 years exacerbates the cons of the longer term. There is even more interest paid over the life of the mortgage, the equity is growing even slower, and the interest rate will generally be higher. Proponents of the 40 year term argue that it allows for an even lower payment so that more people can afford to purchase homes. But, it can also create a situation where people are buying a more expensive home than they should just because they can afford the payment at the 40 year term.

Let's compare the total costs of the same mortgage amount but with differing terms. We will even use the same interest rate for all term lengths, even though the longer terms generally have a higher rate which means even more spent on the interest portion.

Take a $200,000 mortgage at a 5% rate (not including taxes or insurance in the payment):

  • 15 year term: Payment is $1582/ month and total interest paid is $84,686

  • 30 year term: Payment is $1074/ month and total interest paid is $186,512

  • 40 year term: Payment is $964/ month and total interest paid is $262,909

As you can see the longer term results in a much lower monthly payment but it also results in a much larger amount of money spent on interest over the life of the loan.

While I do agree there is a need for more affordable housing and that real estate prices have gotten to a point that home ownership is out of reach for a lot of Americans, I am still a big proponent of the shorter term, 15 year mortgage. The two main reasons are the equity growth and the lower interest paid over the life of the mortgage. That additional money going to interest in the longer term mortgage could be money being invested!

I am going to tell you a quick personal story. Shortly after I graduated from college, I bought my first home. It was a small house but a perfect little starter home. I had some savings for my down payment and I took out a mortgage for the rest. I decided to do a 15 year mortgage even though the larger payment meant less discretionary income in my budget. 3 years after I purchased that home, my plans changed and I moved to another city and sold the home. Because I had chosen the 15 year mortgage, I had already paid down close to 20% of the mortgage amount which gave me a great deal of equity. That meant at selling time, a much larger check coming back to me! If I had chosen the 30 year I would have only paid about 6% of the mortgage amount. That equity made a huge difference in my financial options going forward!

Back to my thoughts on the 40 year option. While the longer term does create a lower, more affordable payment so that more people can afford to buy a home, it doesn't mean that is the best long term financial decision for them. Owning your own home is part of the American dream. Owning your own home evokes a sense of pride and security in most people. But owning your own home can come at a huge cost in interest when you take the longer term. A huge cost that could have been saved for retirement. Plus, if you take on that 40 year mortgage at say age 35, then you will still be paying on that mortgage until age 75, most likely well into when you want to be retired. Most people do not figure they will still be making a mortgage payment in retirement. Worse yet, the mortgage payment may push your retirement age much later. Always consider the long term! We live in a world where most want instant gratification but sometimes saving and waiting yields the best outcome!

Information contained in this post is for educational purposes only and is not considered financial advice.


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