40-year mortgage often a risky choice

Some buyers in high-cost housing markets in the Northeast or on the West Coast have turned to 40-year fixed-rate mortgages in the pursuit of homeownership. Haven't heard of a 40-year fixed mortgage? You may soon. Fannie Mae is engaged in a pilot program with select credit unions that could eventually make the product more widely available if Fannie considers adding this product to its portfolio.

The primary advantage of a 40-year fixed rate mortgage is making monthly payments more affordable without taking on the risk of an adjustable rate. In addition to buyers in high-cost areas, the 40-year fixed mortgage also appeals to buyers with small down payments. Reducing the monthly payments on large loan amounts is accomplished by stretching the repayment term by an extra 10 years.

But the difference in payments may not be as significant as you might think. Consider that a $200,000 mortgage financed for 30 years at a fixed rate of 5.75 percent carries a monthly payment of $1,167.15. All else being equal, stretching the loan term an additional 10 years reduces the monthly payment by just over $100 to $1,065.78.

However, some of this effect of lower monthly payments is negated by a higher rate that is charged on the 40-year loan. Rates on a 40-year fixed are often one quarter to one half of a percentage point higher than a traditional 30-year fixed-rate mortgage. Loans with longer terms carry higher rates because of the added time frame where a default may occur and because lenders and investors seek compensation for the longer period of time that their money is tied up.

Another disadvantage that becomes significant is that the homeowner builds equity at a snail's pace. For first-time buyers looking to eventually move up to another, larger home, this slow pace of equity accumulation is a liability.

Consider a $200,000 40-year fixed rate mortgage vs. a 5/1 ARM for a buyer with an intended five-year horizon in the home. While the 5/1 ARM reduces the monthly payment by $57 compared to a 40-year fixed, the 5/1 ARM borrower accumulates an additional $10,000 in equity during that five year period.

In truth, borrowers rarely take out a 30-year or 40-year loan with the intent of keeping that loan for the duration. But the difference in interest costs and accumulated equity is still considerable for buyers anticipating occupying the home for more than 10 years and that are good candidates for fixed-rate mortgages. In the same example of a $200,000 loan, even at an identical interest rate, the 40-year mortgage costs an additional $4,200 in interest and has a $16,389 smaller equity stake after 10 years. The higher rate typically charged on a 40-year loan only exacerbates the differences.

The increasing trend toward risk-taking with mortgage payments is a little disconcerting at a time of heightened affordability issues and growing consumer debt burdens. While the choice of mortgage product could potentially shave hundreds of dollars from monthly mortgage payments, there are plenty of other aspects of homeownership -- such as homeowner's insurance, property taxes, maintenance, homeowner's dues, and homeowner's assessments -- that are not price negotiable.

Cutting mortgage payments through creative financing introduces the risk of higher payments later, or in the case of the 40-year fixed-rate mortgage, raises interest costs and slows the accumulation of equity through principal repayment. While a 40-year fixed mortgage is certainly a better alternative than an interest-only loan, it still smacks of a budget-constrained buyer desperate to get into a home. If this is the step borrowers must take to qualify for a home or to afford monthly payments, perhaps they should rethink homeownership.