June 18, 2009 in Mortgages

Is the 40-year mortgage a joke?

It’s true: A 40-year mortgage can make your monthly house payment more affordable. But mortgage brokers say such long-term loans generally aren’t the best choice for most borrowers because they typically come with a higher interest rate and cost more in interest over the lifetime of the loan.

This trade-off between a lower payment and higher costs is so unattractive that Jeff Lazerson, president of online mortgage broker MortgageGrader.com, says the 40-year mortgage is “a joke.”

“Amortizing a loan over 10 more years does very little to decrease the payment, and the industry has historically priced 40-year loans more expensively than 30-year loans, so the benefit that the consumer perceives they should get, they don’t get,” he says.

Longer term means more interest expense

To make sense of Lazerson’s comment, consider this chart:

Comparison of payments
Loan amount Interest rate Loan term in years Monthly payment Total payments
$100,000 5% 30 $536 $192,960
$100,000 5% 40 $482 $231,360
$100,000 5.25% 40 $499 $239,520

If you borrowed $100,000 at 5 percent with a 30-year term, your monthly payment would be $536. If you borrowed the same amount with the same rate, but with a 40-year term, your monthly payment would be only $482, a savings of $54 per month.

That might seem like a good deal, but lenders typically charge a higher rate on a 40-year loan due to the perceived higher risk of the longer term. So if you borrowed $100,000 at, say, 5.25 percent with a 40-year term, your monthly payment would be $499. That higher interest rate would reduce your savings to just $37 per month.

Moreover, the longer loan term would result in significantly higher total payments. In fact, the difference between the $100,000 30-year loan at 5 percent and the $100,000 40-year loan at 5.25 percent would amount to $46,560 in additional interest expense. That’s a lot of interest, especially compared with your $37 monthly savings.

This example assumes a fixed interest rate for the entire term of each loan. A fixed rate is typical for 40-year mortgages today, though some of these loans have a fixed rate for three, five, seven or 10 years and then convert to a variable rate. Some lenders used to offer a variation of a 40-year loan called a “30-due-in-40.” This type of loan, which had a balloon payment at the end of the first 30 years, is now uncommon and perhaps even extinct.

40-year loan repays some principal

A 40-year mortgage could make sense for some borrowers who are especially “payment-sensitive” and who need a lower payment to qualify for a larger loan amount or who want the lowest possible payment for the longest amount of time, says Robert Satnick, president of Prime Financial Services, a mortgage brokerage in Van Nuys, Calif.

Unlike an interest-only loan, a 40-year mortgage pays down the principal over time, though the amount paid off is less than would be the case with a 30-year mortgage.

“What’s nice about a 40-year loan — if it’s not an interest-only loan — is that they are contributing something, even though it’s a small amount, to pay down their principal,” Satnick says. “It increases the pride of ownership, rather than, at the end of the five years, (having you) owe as much as you borrowed.”

A 40-year mortgage also gives borrowers flexibility since the payment is lower, but they can still make extra payments to pay off the loan more quickly, says Bob Walters, chief economist at Quicken Loans. The term of the loan “doesn’t have to be locked into 40 years,” he says. “You can’t make it longer, but you can certainly make it shorter.”

Some 40-year mortgages are “Fannie Mae-eligible,” which means the lender can sell those loans to Fannie Mae, one of the secondary market mortgage corporations that operates under federal government conservatorship. The guidelines posted on eFannieMae.com state that this type of loan product “is ideal for borrowers who face affordability issues and think homeownership is beyond their reach.”

Congress may change mortgage rules

A 151-page bill, H.R. 1728, introduced in the U.S. House of Representatives, could change some of the regulations that govern how lenders originate certain mortgages that are deemed to be nonstandard because they can be riskier or more expensive for borrowers than a conventional, 30-year fixed-rate loan. Some analysts have suggested that the bill’s promise of a lawsuit-free “safe harbor” for certain 30-year, fixed-rate mortgages would encourage lenders to discontinue or raise interest rates further on other types of loan products.

Indeed, Rep. Gregory Meeks, D-N.Y., told the House Committee on Financial Services that the bill would encourage “the market to move toward making 30-year, fixed-rate fully documented loans the standard once again in mortgage lending,” according to a prepared statement.

The bill’s future is uncertain, as is the effect it would have on 40-year mortgages in particular; however, borrowers should be aware that Congress has taken an interest in the issue of nonstandard mortgages.

Modification may extend loan to 40 years

Homeowners who can’t afford their mortgage payment may be offered a 40-year term as part of a loan modification agreement. For instance, the federal government’s Home Affordable Modification program extends the loan term to 40 years if the payment is still more than 31 percent of the homeowner’s income after missed payments and other arrearages are added to the loan balance and the interest rate is lowered in small increments to just 2 percent.

Whether a 40-year mortgage makes sense for these borrowers depends largely on whether they can afford the modified payment, Satnick says. If they can make the modified payment and meet their other monthly expenses, a 40-year term may make sense. If not, the modified loan may not be sustainable.

“They have to be very honest with themselves,” he says.

The bottom line on 40-year mortgages may be that, like most loan products, their wise or foolish use depends mainly on the borrower’s financial goals and objectives.

“There is nothing inherently wrong with it; there is nothing inherently right with it,” says Walters. “It’s simply a longer term that usually takes longer to pay off but gives you a lower payment. It’s as simple as that.”

Create a news alert for “mortgage”