Long an oddity in the lending industry, the 40-year mortgage finally has joined the mainstream of home loans. Fannie Mae, which buys roughly one out of every four conventional U.S. mortgages, started buying the longer-term loan on June 1, putting it on an equal footing with the more-familiar 30- and 15-year fixed-rate, interest-only, and adjustable-rate mortgages (ARMs).
For lenders, Fannie Mae's move means they likely will offer more 40-year loans because lenders no longer need to keep and service the loans themselves, wait for the loans to be paid off, collect monthly payments, handle property taxes, and so on. They will be able to sell the 40-year loans, using cash from the secondary market to create other loans.
But what about consumers? How will they be affected? Sandy Cutts, a Fannie Mae spokesperson in Washington, D.C., explains that a 40-year mortgage is just like a 30-year mortgage -- only 10 years longer. Cutts adds that Fannie Mae is willing to buy both conventional loans and ARMs that can be paid off over 40 years. We ll look at the mechanics and costs of both types of 40-year mortgages a little later.
So who would use a 40-year mortgage? There are two types of people who use 40-year loans, she explains. They are for those who are experiencing financial problems because they live in financially challenged markets where affordability is an issue, and for those people -- often first-time buyers -- who are concerned about making their payments manageable. It has its pros and cons. Its greatest advantage, the longer amortization period, is also its greatest disadvantage. She adds, however, that since homebuyers typically move or refinance their loans every five to seven years, the long-term costs are not really an issue for most people. The issue is the size of the monthly payment and how much house that payment can buy.
The key point is that the monthly payment is lower a 40-year loan. It (40-year loan) is not for everyone, Cutts points out, but that lower payment means there is more money available every month that can be used to pay other bills. It can often make the difference between owning and not owning a home.
Before comparing 30- and 40-year mortgage costs, consider that 40-year mortgages are slightly more expensive rate-wise simply because the lender is risking money for an extra 10 years. The interest rate on a 40-year mortgage, on average, is 0.25 percent to 0.375 percent higher than on a 30-year, she adds. This applies to both the conventional and ARM loans. And while ARMs with a 40-year duration are still rare, the fact that Fannie Mae is now buying them guarantees you will be seeing more of them. So a 3-year ARM spread over 30 years with a starting interest rate of 4.5 percent probably would translate into 4.75 percent for a 3-year ARM over 40 years.
But let s focus on the conventional mortgages, the most common 40-year loans. A 30-year, $150,000 conventional loan at 5.5 percent would require a basic monthly payment of $851.68. That would be interest and principal, and would not include taxes, insurance or any assessments or fees. As we have seen, to get that same loan spread over 40 years you would pay a bit more. If you could get it for 5.75 percent, your basic monthly payment would be $799.33 a month, for a monthly savings of $52.35, which works out to $628.20 a year. On a $250,000 loan the basic monthly payment for a 30-year loan at 5.5 percent would be $1,419.47. A 40-year mortgage at 5.75 percent would require a payment of $1,332.22. The difference here is $87.25 a month or $1,047 a year.
While many of the people who use 40-year loans are doing so because money is tight, a lot of people will use them because homes are so expensive. So let s look at a loan for $359,650 - the most you can borrow before getting into the jumbo loan category (which Fannie Mae won t buy) and the different requirements, conditions and interest rates that kick in at that threshold.
In some parts of the country, $359,650 might buy you a fixer-upper starter home -- one of those places real estate agents like to describe as having plenty of potential. The monthly payment on a $359,650, 30-year loan at 5.5 percent would be $2,042.05 compared to $1,916.53 on a 40-year at 5.75 percent. The difference here works out to $125.52 a month, or $1,506.24 a year.
The payments on the 40-year loan are definitely lower, but the amount you pay in interest is higher - much higher. While it is true that the interest is tax deductible, the simple fact is that you are still paying a lot more in interest, and that extra interest does nothing to reduce the principal. Let s look at that $150,000 loan again. Over 30 years the total interest at 5.5 percent would be $156,606.06. Over 40 years at 5.75 percent, it would be $233,670.10. Now let s look at the $359,650 loan. Total interest on the 30-year loan would be $375,489.13 compared to $560,284.59 with the 40-year.
Sure, almost no one keeps a loan for the full term. But every dollar you pay in interest reduces the amount that goes toward principal. At the end of the first year with the $150,000 loan, the person with the 30-year loan would have reduced the principal by $2,020.59. The one with the 40-year mortgage would have reduced it by $992.85 - a $1,027.74 difference. With the bigger loan, the difference is even more. After the first year with the $359,650 as a 30-year loan, the total principal paid would be $4,844.77. With a 40-year it would be $2,380.57 -- a difference of $2,464.20.
Obviously this does not take into account how much the property value might increase over time, but how many of us look at what our paid equity will be in one year, or even five or 10? What we look at is the house. While it is important to understand the pros and cons of a 40-year mortgage, the key to remember is what you are getting for your money -- a home of your own. Now that Fannie Mae has started buying 40-year mortgages, more people might be able to afford to buy a place to call their own.