The 40-Year Mortgage
Last year, the Federal Housing Authority started to talk about 40-year mortgages, and lenders and mortgage brokers have been gauging borrower interest ever since while feeling out the legal and ethical complexities.
Why would someone want a 40-year mortgage? To the debt averse, the thought of carrying such a long liability is pretty anxiety inducing, but to others it is an intriguing concept. From my perspective, for 99% of borrowers, the answer of when a 40-year mortgage is appropriate is never. Not only is having debt hanging over your head for that long just not a great way to go through life, but it is the simple math of it all: for a $400,000 mortgage with a 6.0% interest rate and a 30-year fixed term, the monthly payment would be $2,398. Over the life of that 30-year term, the total amount of interest paid would be $463,352. But that same loan with a 40-year term would generate total interest paid of $656,410, a difference of nearly $200,000. Same house, same interest rate, but $193,058 “more expensive” because the length of the term stretches the payments out, which generates more interest paid over the extra ten years.
For the small number of people who may benefit from a 40-year mortgage, the key is in the monthly payment. The 30-year mortgage above generates a monthly payment of $2,398, but the 40-year mortgage would have a monthly payment of $2,201, a savings of nearly $200/month as compared to the 30-year. For some homebuyers especially young people just getting started out with more limited income, that savings is meaningful. Granted, the extra ten years of the term mathematically outweighs the monthly savings by quite a bit, but like I said, at the beginning of a mortgage a savings of $200/month is pretty real for a lot of people.
It would be easy to say that if people cannot afford the monthly payment on a home with a 30-year mortgage, they simply should not buy a home because they are not truly ready. And while that is an argument that does make a fair amount of sense, the combination of rapidly rising interest rates and much higher home prices has boxed a lot of would-be homebuyers out of the market. If you believe that a key aspect (to many, at least) of the American Dream is home ownership, and building equity in a home is one of the best ways to ensure long-term financial stability that also can build intergenerational wealth, then providing better opportunities for home ownership for those just getting started out and those who have been historically excluded from the home market is a worthy goal. (Addendum from the archives: A Home as an Inflation Hedge).
And that, in fact, is why the government has started to become open to the concept of 40-year mortgages. Most banks are not doing them yet, to be sure. The primary reason is likely that Fannie Mae and Freddie Mac will not purchase 40-year mortgages from banks at the current time, so banks have to keep them on their own books for the life of the loans. And 40 years is, well, a long time. Some smaller banks and mortgage brokers appear to be nibbling at this edges of this type of mortgage, however, and time will tell if offerings example in the years ahead.
I mentioned at the outset that the Federal Housing Administration is becoming more tolerant of 40-year mortgages. But FHA’s involvement at least for now is only to allow an existing mortgage to be modified into a 40-year mortgage. And modification rules are strict with modifications only allowed if the homeowner is in financial peril and other adjustment mechanisms have failed. The FHA calls such modifications “a loss mitigation home retention option.” The idea behind allowing a modification into a 40-year mortgage is to help homeowners stay in their homes if they find themselves in financial trouble. This is not only on the grounds of compassion, but also because it helps to prevent these mortgages from being defaulted upon, which, as we saw during the 2008 Financial Crisis, can have a contagion effect throughout the entire economy. So the dual policy objective of keeping people in their homes and not having busted mortgages crater the economy is what’s behind the FHA’s interest in 40-year options.
Time will tell if more banks start to offer 40-year options. The primary motivating factor will probably be whether consumers actually want them. If they do, you can bet there will be a bank or a mortgage broker willing to provide it. And let’s face it, the extra interest over the life of a loan is a compelling profit motive for some mortgage originators. But this is also likely to be a tightly regulated market, as well it should be. I think it is safe to say that many Americans are not great a math, and a smooth, salesy mortgage broker could pitch a 40-year product that saves the borrower $200/month on the front end without adequately explaining the back-end. Regulators can and will step in to protect the consumer.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. © Ben Sprague 2023.
Busy week on the home-front and with work, so no Weekly Round-Up this week. I’ll be back next week with more content. Have a great week, everybody!
This is great, Ben.
I wonder if the additional interest paid over the life of the loan is the right metric to evaluate whether these 40y loans make sense?
A user cost model would suggest that, as long as the interest rate over the life of the loan is sufficiently low (and over 40 years there’d probably be many chances to refi), and making some modest assumptions about housing appreciation v rental price growth, maybe going from a 30y to a 40y mortgage wouldn’t chance the typical result: buying is often preferable to renting?