An Assessment of 40 Year Loans
Mortgage products offered by lenders continue to become more creative as they look for ways to appease borrowers looking to both keep their monthly housing payments low and purchase increasingly expensive homes. One of the products being pushed is the 40-year loan.
The 40-year mortgage is being marketed to borrowers looking to keep their monthly payments low, but who are also concerned about interest rate risk. 40-year mortgages do keep monthly loan payments down, but they also cost more over the term of the loan.
The 40-year mortgage was first offered in the 1980s, but have never really caught on as a mortgage product. These loans have had a surge in popularity recently, however, as Fannie Mae recently decided to begin purchasing more of them. More banks may, in turn, be willing to offer the 40-year mortgage since they know that Fannie Mae will purchase them.
When Fannie Mae makes decisions, such as their choice to purchase 40-year loans, they give the product credibility. As a result of Fannie Mae's interest in these loans, many mortgage lenders are now beginning to offer the 40-year mortgage.
40-year mortgages are much more costly in the long-term. This is, obviously, because the repayment term is 10 years longer, meaning that borrowers will pay a lot more interest. It is also because the rates on these loans are anywhere from 0.25 to 0.377 percentage points higher than the rates on the more traditional 30-year fixed rate mortgage.
The table above shows a comparison between the interest paid on a 30-year versus a 40-year mortgage assuming the same $200,000 principal and 5.75 percent interest rate. If the rate on the 40-year mortgage increases to 6 percent, the total interest paid jumps to $328,000.
Mortgage lenders are continuing to adjust their products in creative ways to attract borrowers. One of the more popular adjustments is called a 20-20 mortgage. It is a 40-year mortgage with a single rate adjustment that takes place after the first 20 years. This mortgage is really just two separate 20-year mortgages. The appealing part is that the rate on this loan is 0.125 to 0.25 point lower than the rate on a conventional 30-year fixed rate mortgage.
40-year loans are a preferred option to more risky interest-only loans
In our opinion, the 40-year loan is a much more attractive option than the various ARMs (adjustable rate mortgage) and interest-only loans being offered by lenders. These loans have been extremely popular with borrowers trying to keep their monthly payments as low as possible. These loans give them more purchasing power in the surging housing market, but come with a price.
Many in the mortgage industry worry that both borrowers and lenders are assuming high risks that may cause very serious problems in the future. Even Federal Reserve Chairman Alan Greenspan has weighed in on the subject when he told Congress, "The apparent froth in housing markets may have spilled over into mortgage markets." With this comment, he was referring to the rapid rise in the number of interest-only loans and other creative loans being offered by the mortgage industry.
Interest-only loans allow borrowers to significantly lower their monthly mortgage payment. Where ARMs allow borrowers to receive a lower interest rate in exchange for accepting the risk of future rate increases, interest-only mortgages have the same interest rate over the life of the loan. These loans are much more costly than conventional mortgages, with the interest rates being 0.125 points higher on average. This, however, isn't the worst aspect of the interest only loan.
When the interest-only period ends, the mortgage payment increases dramatically. Let's take a $200,000 loan with a 5.50 percent interest rate to illustrate what happens when the 15-year interest-only period ends. The principal repayment period will be 15 years, resulting in a payment increase from $917 to $1,634 per month.
Comparing payments for different types of loans
The following comparison shows what a borrower would pay for every $100,000 with three different mortgage products.
- 30-year fixed rate - At an interest rate of 5.56 percent, the payment would be $572 per month for principal and interest.
- 30-year fixed rate with an interest-only period - At an interest rate of 5.69 percent (remember, these are 1/8 points higher), the payment would be $474 per month during the interest-only period. The payment increase in the payment amount after the interest-only period will depend on the length of the interest-only period.
- 40-year fixed rate - At an interest rate of 5.81 percent (these rates are also higher), the payment would be $537 per month for principal and interest.