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40-year mortgages: lower payments, slower equity

Rapidly rising home prices could increase the popularity of 40-year mortgages.

For a given amount, a 40-year mortgage carries lower monthly payments than a 30-year home loan. That means a 40-year mortgage allows you to afford a slightly more expensive house. The longer loan term has disadvantages: You pay more interest and build equity slower.

Forty-year mortgages have existed for a few years and have gradually grown in popularity. Not all lenders offer them, and lenders structure the loans in different ways. A few lenders offer 40-year fixed-rate loans, just as they offer 15-year and 30-year fixed-rate mortgages. More commonly, lenders offer a 40-year amortization on adjustable-rate mortgages, or ARMs. A customer might get a 5/1 ARM with five years of fixed payments and 35 years of annual rate adjustments thereafter.

Making room for more house
No matter how the loan is structured, the benefit to the borrower remains the same: lower monthly payments.

Nationwide, the median resale prices of single-family homes increased 8 percent from the first quarter of 2001 to the first quarter of 2002. In Mobile, Ala.; Worcester, Mass., and Long Island, year-over-year home prices jumped more than 20 percent. In places with rapidly rising values, some home buyers will try 40-year mortgages before they are completely priced out of the housing market.

Astoria Federal Savings, a Long Island-based thrift, offers adjustable-rate mortgages amortized over 40 years. The longer-term mortgages are useful in an era of rapid increases in home values, says Gary McCann, senior vice president of Astoria. "They can buy a little more house," he says. "It's more affordable and they can stretch their payments out a little more."

Here's how: Let's say you can afford to pay $1,750 a month for principal and interest, excluding taxes and insurance, and that you can get either a 30-year or a 40-year mortgage at 7 percent interest. (That would be a high rate in the middle of 2002, but a low rate in most years.) With the 30-year loan, you can afford to borrow a maximum of $263,044. With a 40-year loan, you can afford to borrow up to $281,610. The 40-year loan allows you to borrow more than $18,000 more.

Slow equity loan
You pay huge buckage for the privilege of taking out that 40-year loan for a slightly larger amount, though: $191,426 more. That's how much more interest you would pay over the life of the 40-year loan in the example above -- partly because you're borrowing a little more, but mostly because you're paying interest for 40 years instead of 30 years.

That objection to 40-year mortgages has a flaw: Most mortgages are paid off early, anyway, when the borrower refinances the loan or sells the home. Hardly anyone is going to make payments on the same mortgage for 40 years.

Another drawback to a 40-year mortgage: You build equity more slowly. With that 40-year loan in the example above, you would pay $107.29 in principal the first month. With the 30-year loan, you would pay $215.61 in principal the first month -- building equity quicker on a slightly smaller loan amount.

Although borrowers can use 40-year mortgages to squeeze into more expensive houses, that's not a great reason to get one.

"I would not recommend that anyone use a 40-year amortization to be able to afford more home than under a 30-year loan," says Daniel Roe, a certified financial planner and principal with Budros & Ruhlin financial advisers in Columbus, Ohio. "The best plan is to figure out what you can comfortably afford and then structure the mortgage that is best, given your overall goals."

Savvy savers only
This advice comes from a guy who had a 40-year loan on a previous mortgage. He didn't get a 40-year mortgage to buy more house than he could afford otherwise; he took out the longer loan so he could invest the difference between the payments on a 30-year loan and a 40-year loan.

"I took the 40 and immediately bumped my monthly savings into my portfolio by that amount," Roe says. "The strategy should be used by disciplined savers to build equity outside of their personal residence. If you can invest the monthly difference over the long term at a rate greater than your mortgage rate, then you will build more wealth."

McCann, of Astoria Federal Savings, agrees that savvy investors can use 40-year mortgages to contribute more money to their portfolios. On the other hand, he thinks it can be wise, under some circumstances, to use a 40-year mortgage to buy a home that would be unaffordable with a 30-year loan.

"Some people are looking to just get in there initially and get established, get on their feet, and more than likely in the next five or seven years, they'll be refinancing anyhow," he says.

McCann likens 40-year mortgages to interest-only mortgages. Both are sometimes used by people who expect a big pay increase in the next few years, or who plan to own their houses for a fairly short time and feel confident that sale prices will appreciate.