Should You Get a 40 (or 50) Year Mortgage?

I recently read a post arguing that one should go for a 30 year mortgage when possible, but it is not that big a deal to go for 40 and 50 year mortgages if it is necessary. These very long-term mortgages are offered in some of the west coast cities and are touted as options for bringing home ownership within the reach of the common man. I had initially dismissed these types of mortgages as an exotic type of mortgage that not many banks offer, and even if they did, not many people will consider going for it. But I was quite surprised during my trip to California last week, when this topic came up while chatting with and a bunch of friends and it turned into quite a heated discussion. Here are some of the arguments and alternatives that some of us who were against the 40 year mortgage brought up, with some number crunching added in to make the case more powerful. I know some of you believe that 40 year mortgages are a blessing that can make home ownership possible for you, and I understand that if you have made up your mind, I could possibly not sway you. That said, please read through the arguments here before taking out a 40 year mortgage – if nothing else, you will know more about what you are getting into.

The interest rate is usually higher on a 40 year loan
Since the 40 year loan has 10 more years during which a person taking the loan can default, it is a higher risk for the banks. To compensate for this, the banks charge about a quarter of a percent point higher interest rate on 40 year loans compared to 30 year loans. So by going for a 40 year loan, you agree to pay a larger interest for a longer term.

Very little reduction in monthly payments
Going for a 40 year mortgage instead of a 30 year mortgage is not going to reduce your monthly payments drastically. Consider a loan of $500K. That will still not buy you much in many of the “hot” cities in California, but with the real estate market coming down, my friends aim for something in this ball park after putting 20% in down payment. A 30 year mortgage with a 5.75% interest rate on the 500K loan will result in a monthly payment of $2917.86*. On the other hand, a 40 year mortgage with a 6.00% interest rate will result in monthly payment of $2751.07*. That is a difference of $167 per month. That’s not a whole lot!

Too much additional money thrown away in interest
For the loan above, for the 30 year loan at 5.75%, the total interest (not including principal) is $550K* (yeah, my jaw dropped open too!). On the other hand for the 40 years at 6.00% the total interest (not including principal) is $820K*! That is a difference of $270K! In other words, you have 270K less saved up for your retirement (or other goals) and the bank is richer by 270K. I feel that is just not justifiable!

Takes a long time to build equity
The amortization of the mortgage means that in the first few years, most of your monthly payments go towards paying off the interest and a very small amount actually applies to the principal. For the 40 year loan, in the first monthly payment, $2500* will go towards paying the interest, while only $251.07* will be applied to the principal. What this means is that, it will take a long time for you to build equity. For instance, for the 40 year loan considered above, it will take you 11.5* years to pay down 10% of the principal. Compare that to 6.5* years that it will take for you to pay down 10% of the principal on the 30 year loan considered above.

Do you really want a huge monthly bill even in retirement?
How long do you plan to work? If you are like me, you want to be able to at least partially retire by the time you hit your 50’s (if not, much sooner!). Say you start working at the tender age of 20. By the time you retire (fully or partially) at 50, you will still have a decade more of payments to go! How do you plan to support your retirement, if you have a fixed monthly bill every month that is by no means a small amount? If you wait until your mortgage is paid off before retiring, you have to wait until you are 60. And if you buy your home later in life, which by the way, is more likely, add that many years to your retirement age! Still think that 40 year loan is juicy?

OK, supposing that you agree with me that it’s not a good idea to get a 40 year mortgage. How else can you afford a home in a market with these soaring house prices?

Buy an older or smaller house
For instance, if you are willing to spend ~$2750 per month on mortgage anyway (from the calculation above, this is the monthly payment for the 40 year loan), going for a 30 year loan with 5.75% interest rate requires you to stay to a loan amount of $470K* instead of the original $500K you were considering. Going for a slightly older home or a smaller one could possibly put a house in that price range, ridding the need to go for a 40 year loan. It may not be your dream home, but it can still be a decent starter home which you could possibly flip after a few years to buy a bigger/newer home.

Move to a different location where the house prices are not that high
The difference in interest alone of 270K between the 30 year loan and a 40 year loan is sufficient for you to buy a large 3000 sq ft. 4-bedroom mansion in Texas! No matter what anyone tells you, believe me, Texas is a very live-able state. Dallas and Houston are huge metro areas which can rival most other big metros in the US in terms of culture, nightlife and job opportunities (and, unfortunately, the traffic too). Austin is deemed the live music capital and is a medium sized city with a vibrant culture (They have a logo “Keep Austin Weird” - it’s true!). San Antonio is another wonderful option, but job opportunities for the techies may not be as abundant as the other cities. And that’s just Texas. There are a lot of other states that have cities with similar profiles and a very affordable housing market. So reconsider if you indeed want to be in the city you currently are in.

Rent out your basement or a spare bedroom
When I did an internship in California, I was hosted by a family in their spare bedroom. This is not an option for everyone, though. It depends on how willing you are to let a stranger into your house and how it might impact your privacy. Fortunately, I got along very well with the family and it felt like a home away from home. It was a single income family, and subletting the room helped them keep up with the monthly mortgage payments. I am not sure of the legal implications of this though. Since I was there for only a few months, I did not bother about it much. But if you consider this seriously, I recommend you educate yourself about the legal (and tax?) implications first.

Share the mortgage with someone
This one sounded very strange to me, and I personally would probably not be able to do it. But since it came up the other day, I decided I will mention it, and maybe some of you can provide more details. Apparently, in some cases, two friends get together and get one house, and share the mortgage. Most likely a split level plan. The kitchen and the living areas are “common” areas, while the bedrooms are owned “individually”. Also, I believe there are homes with two master bedrooms that support this kind of a deal. Again, this sounds very strange to me, and I have no idea of how this works. If you know more about it, please share it with me and the other readers.

So, the bottom line is, by getting creative you can find different ways to own a home even in a market where the house prices have sky rocketed, without having to resort to a 40 year mortgage. So, please think carefully before signing up for a longer mortgage term. Is the true cost really worth it?

*All calculations based on mortgage calculators.

Message from sponsor: You can read more about cheap mortgages here.

If you like this article, you can bookmark it or subscribe to the feed.


david said...

The problem here in LA is that $500K will get you a 1 bedroom condo in a nice area. If you are looking to buy a house, $500K is not going to get you much of anything where I live.

As I mentioned in the article, a 40 or 50 year might be the only way for people to stay in the town/school district,etc, they love and make it "affordable". For some people, there is no other way, unfortunately. But good points and advice!

ispf said...

David: This was exactly the argument some of my friends were making! We actually pulled open the laptop and crunched some numbers to see the difference in monthly payments! To me, the small reduction in monthly payments compared to the big amount in total interest paid seems unjustified. I guess you need to be a Californian to feel/understand the logic behind these loans! For now though, lets just agree to disagree :)

MossySF said...

If the interest rate was the same between 15/30/40/50/60 year loans, I'd pick the longest term and pay extra on my own schedule.

Gaming the Credit System said...

There was a good long post/discussion about this at All Financial Matters (also here) and the basic result was that if you can get a good interest rate on the mortgage and you have a plan or method for earning a higher interest rate in some other investment, it is *always* better to take the longer mortgage (or even an interest-only mortgage) and invest the money you would have paid. The initial post compared 15 vs 30 year mortgages, and the follow-up looked at interest-only mortgages.

ispf said...

MossySF: If the interest rates are same and if the person is disciplined, what you say makes perfect sense. We are doing something similar and will pay down our 30 year mortgage in less than 15 years.

GTCS: Yeah, I remember that discussion on AFM. There are two things at play here -
a) Stretching the mortgage longer will make sense only if you can guarantee that the interest rate on your investment will be higher than your mortgage rate. Paying the minimum on mortgage and investing the rest in stocks/mutual funds etc can provide the higher rate of return but there is no gurantee. If the stock market crashes, you have neither the equity on the house, nor the stocks. With a huge loan like mortgage, I would rather err on the conservative side.
b) In the particular case of this post, people who choose a 40 year loan do so most likely because they cannot afford the monthly payments on a 30 year loan. So, there is *no extra money* that can be invested. In such a situation, going for the longer loan term only means that the interest paid will be higher. Maybe some of the options I suggested or considering not buying a home until financial situation improves, is better in this situation.

Anonymous said...

You're missing the bigger picture. As a home owner, you deduct the interest on your loan from your taxes. So if my interest payments for the year total $15,000, then I take $15,000 off of my taxable income. If I'm in the 33% tax bracket (chosen for simplicity's sake), then the government is paying me 1/3 of my housing loan's cost of borrowing those funds. This make the effective APR somewhat less.

I think building equity in a home is stupid. You are putting your liquidity into a fixed asset such that you can't easily get to it, it is at risk from housing market volatility, and, if you're in dire straights, banks are much more likely to foreclose on homes with lots of equity than on homes with little equity. This last point seems strange, but think about it -- if you have paid in half your mortgage principle on a 200,000 loan, then the bank only has to sell your home for 100,000 to break even. With zero equity in the home, the bank has to sell it for 200,000 to break even.

When you think about the net cost to you, it might even make sense to buy a home on an interest-only mortgage -- that way your cost of borrowing is subsidized by a third, reducing your tax profile, and you'd have to pay rent somewhere anyway. It makes much more sense to take the interest-only mortgage, then calculate how much of the principal you would have paid off and put that amount of money each month into a long-term investment.

ispf said...

Anonymous: Good argument. I understand the logic, but can't bring myself to not payoff my mortgage quicker. I spent some time after writing this post thinking about the reasons for my seemingly irrational behavior. I have summarized my thoughts here in case you are interested.