The Lesser-Known 40-Year Mortgage: What You Should Know
Anyone spending a little time with a mortgage calculator quickly realizes that stretching out the length of a mortgage loan can dramatically lower monthly payments. Payments on a 30-year mortgage, for instance, are considerably lower than those on a 15-year mortgage.
But when it comes to longer terms, can you ever have too much of a good thing? Put another way: Is a 40-year mortgage really worth considering?
The idea is not as radical as it might seem. Actually, 40-year mortgages have existed in the United States for some time, although they are much less common than shorter-term offerings.
Given the sharp rise in real estate prices in some parts of this country, a 40-year mortgage might seem like a reasonable proposition. However, there are also added costs and hurdles associated with a 40-year loan. Like most financial instruments, they are neither inherently good nor bad; what matters is how they are used.
How does a 40-year mortgage work?
Technically, 40-year mortgages can have either fixed or adjustable rates, though fixed-rate loans are more common. A 40-year mortgage would magnify the risk of an adjustable rate loan, simply because such a long period of time allows for huge potential changes in interest rates. For example, over the past 40 years, long-term mortgage rates have fluctuated between a low of 3.35 percent and a high of 18.45 percent. Such a range would have a drastic effect on a monthly loan payment, making a 40-year adjustable rate loan an unacceptable risk for most homeowners.
As for a 40-year fixed rate mortgage, structurally this would work a lot like a 30-year fixed rate loan, only with a longer repayment period. That longer repayment period means the principal of the loan is spread over a longer period of time, which is why the monthly payment is lower. However, repaying the principal more slowly means that you have to pay interest on that principal for a longer time period. That means a greater total interest expense over the life of the loan.
Besides the direct impact of the 40-year time frame on your principal and interest payments, the 40-year option has two other important implications. First, it means that these are considered non-qualified mortgages. Non-qualified mortgages are not eligible for purchase, guarantee or insurance from government agencies like the FHA, VA and USDA, or from government-sponsored enterprises like Fannie Mae and Freddie Mac. This means fewer lenders will offer these loans, and they may be subject to tougher underwriting standards.
Another noteworthy consequence of the 40-year loan term is that longer loans generally carry higher interest rates, so 40-year mortgage rates are likely to be higher than 15- or 30-year rates. Thus, with a 40-year loan you would not only be paying interest for a longer period of time, but you would be paying it at a higher percentage rate.
Advantages of a 40-year mortgage
Given their characteristics, why consider a 40-year loan? Well, they do have advantages that may be particularly useful in a couple of situations.
As noted previously, 40-year mortgages lower your monthly payment by spreading the loan principal out over more time. For some Americans, those lower payments might make the difference between affording and not affording a home purchase. While the longer time period does result in greater interest expense over the life of the loan, this added expense is partially offset by the tax-deductible status of mortgage interest payments.
Lowering monthly mortgage payments can have another advantage beyond helping you afford a home: Leaving more room in your monthly budget to make ends meet can help you avoid taking on credit card debt, which carries interest rates considerably higher than those associated with mortgages.
Here’s how these advantages might be applied in a couple of situations. First, in some parts of the country, residential real estate prices have gone through the roof. In 2016, Coldwell Banker found that the 25 most expensive real estate markets in the United States all had an average price of over $1 million for a four-bedroom, two-bathroom house. Even for people with above-average incomes, being able to afford a home in such markets may require a little extra help. Enter the longer repayment schedule with a 40-year mortgage.
Remember, markets with high home prices also typically have high rents, so even the added expense of 40 years’ worth of interest payments may be the lesser of two evils compared with committing to paying escalating rents for the foreseeable future.
To consider another type of situation, a 40-year mortgage might act as a temporary way to help a young person get into the housing market. Even people with promising careers are likely to start out at much lower wage levels than they will eventually earn. Despite those lower wages, their family situations or the nature of the local housing market may dictate that it makes sense to buy a home as soon as possible. A 40-year mortgage might lower monthly payments enough to make that possible. Left open is the possibility of eventually refinancing into a shorter-term loan once the borrower’s income has risen enough to afford higher monthly payments.
Downsides of 40 years
While the lower monthly payments of a 40-year mortgage might seem like the ideal solution in certain situations, it is important to remember that those lower payments are something of an illusion. This approach to financing a home will work out to be more expensive in the long run.
First of all, the fact that 40-year mortgages are longer and nonqualified loans makes them riskier to lenders. That means you are likely to be charged a higher interest rate than for a 30-year loan, typically 10 to 30 basis points more, according to the National Association of Realtors.
Beyond the higher interest rate, the fact that you will be paying interest for an extra 10 years adds considerably to the total interest expense over the life of the loan. The table in the next section of this article will show you how the interest expense of a 40-year mortgage compares with that of a 30-year loan. This expense mounts up not just because of those 10 extra years of interest payments, but also because you will be paying down the principal of the loan more slowly. Thus, even head-to-head over the first 30 years, the 40-year loan will rack up greater interest charges because a higher interest rate is being applied to a larger remaining principal balance.
This slower repayment of principal means you build home equity more slowly. Low equity may limit your future flexibility to refinance or secure a home equity loan. It may even mean you can’t afford to sell your home if a price decline puts the value of the property under water, or below the remaining loan balance.
Then there’s the reality that a financial commitment of that length may last into your retirement years. If you see yourself wanting to stay in your home for the long term, this means you have to consider not just how the mortgage payments fit your budget now, but how they are likely to fit once you retire, when your income may be lower.
Speaking of retirement, one advantage to paying off your mortgage before you retire is that the absence of mortgage payments can allow you to accelerate your retirement saving in the later years of your career. If you are still making payments on a 40-year mortgage throughout your entire career, it may effectively crowd out retirement savings.
Getting back to the fact that 40-year mortgages are nonqualified mortgages, there are some added disadvantages in that as well. For one thing, such loans are going to be harder to find, and you can expect to have to meet tougher ability-to-pay standards in order to qualify. In turn, the more limited choice of lenders means there will be less opportunity for you to comparison-shop for better rates and more savings.
Comparing 30- and 40-year loans
The table below illustrates the financial impact of stretching a mortgage to 40 years from 30, for both better and worse.
In each case, a $300,000 loan was used as an example. For the 30-year loan, a 3.9 percent interest rate was used because that was the average rate as of mid-2017 and is representative of the level of 30-year rates generally available in recent years. A 4.1 percent rate was used for the 40-year loan because 20 basis points higher is the midpoint of the typical spread between 30- and 40-year mortgage rates, according to the National Association of Realtors.
|30-year mortgage||40-year mortgage|
|Total amount paid||$509,401.66||$610,818.21|
Notice two things in particular about this table. The 40-year mortgage does its intended job in the sense that it lowers the monthly payment by just over $140. However, the other key difference is that between a slightly higher interest rate and 10 years of additional interest payments, the total cost of the loan goes up by more than $100,000.
To think of it another way, moving from a 30- to a 40-year loan cut the monthly payment by 10.1 percent, but it boosted the total cost of the loan by 19.9 percent. Forty-year loans are appropriate tools for some situations, but a borrower should think long and hard before making that kind of a decision.
How to get a 40-year mortgage
To get a 40-year mortgage, you must look for lenders that make nonqualified mortgage loans. You will not find 40-year mortgage rates as widely advertised as rates for more common types of loans, but you might start by inquiring of lenders with competitive 30-year rates whether they also write 40-year loans.
Try to find a few such lenders so you can collect some rate quotes and make comparisons. Then ask them about their underwriting standards. Expect these to be more demanding than for a qualified loan. This might entail requiring a higher credit score, a larger down payment or a lower debt-to-income ratio (DTI) — or all three.
Finally, in addition to comparing rates and closing costs as you would with a normal mortgage, it is especially important with a 40-year mortgage to check for prepayment penalties. Over such a long period of time there is an especially good chance that you will want to refinance or sell the home at some point, so if possible you should avoid or at least minimize any penalties for terminating the mortgage early.
Alternatives to consider
Since there pros and cons to the 40-year mortgage, it is important to consider alternatives. Here are some possibilities:
- Pursuing interest-only loans. In the near term, these could lower your monthly payments by even more than a 40-year loan would, but they are also more risky. Basically, they entail paying only the interest on your loan for an initial period of time (generally five to 10 years), with principal payments kicking in alongside ongoing interest payments later on. This may be a cost-effective approach if you plan on moving or are otherwise confident of being able to pay off the loan in a few years, but it can be a risky approach if you have to live with the loan long-term. People who enter into these loans are often shocked by the size of the payments once the principal kicks in, and in the meantime you will build no equity in the initial years of the loan while you are paying only interest.
- Buying a smaller home. Americans have become increasingly drawn to larger homes over the years. According to the Census Bureau, the average square footage of a new home built in the United States increased by more than a third between 1980 and 2010, but ask yourself if you really need all the extra room — especially if you live in a high-cost area. Getting by with a little less room might lower your monthly mortgage payment enough to make a shorter-term loan more affordable.
- Waiting longer to buy. Another alternative for lowering your monthly mortgage payment is to wait longer to buy so you can build up a larger down payment. That larger down payment will not only reduce the amount of principal you need to borrow, it could also yield more favorable loan terms.
- Choosing a different neighborhood. Real estate price differences are often very localized. Being willing to settle for a slightly less trendy neighborhood or deal with a slightly longer commute could save you tens of thousands of dollars on the price of a home — enough to make the monthly payments on a shorter-term loan affordable and allow you to reduce your interest expense in the long run.
Perhaps the best advice for anyone considering a 40-year mortgage is that when dealing with such a long-term commitment, it’s important to think well into the future. The immediate benefit of a longer loan will be immediately apparent in the form of a lower monthly payment, but it is the continuing commitment and eventual total cost that you’ll have to live with for years to come.