40 Year Mortgage Is Usually A Bad Idea

Although they have become much rarer thanks to rapidly-falling real estate prices, the 40 year mortgage is here to stay.  Once prices begin rising and home affordability again becomes an issue, I have no doubt 40 year mortgages will become more popular than ever.  I don’t think this is necessarily a good thing.

Origins Of The 40 Year Mortgage

In the olden days, mortgages required a sizable down-payment and carried terms of only 5-10 years.  Since only the wealthy could afford to own property anyway, the large monthly payments associated with such short repayment terms wasn’t much of a challenge.  Wealthy buyers used mortgages as a way to achieve short-term liquidity, not as a way to leverage their investments in real estate.  Around the beginning of the 20th century and especially following the post-WWII economic boom, 15 and 30 year mortgage loans become the norm as home-ownership came within the reach of more and more Americans.

As expected, easier access to borrowed money boosted home-ownership rates and real estate prices along with it.  As home prices increased (about 1% over inflation, historically), real estate became less and less affordable for the average American family.  Early on in the recent boom in home prices, consumers in some of the more expensive markets such as Manhattan, San Francisco, and Los Angeles increasingly realized the monthly cost of owning a home was simply unaffordable, leading to the proliferation of creative mortgages designed to minimize monthly payments i.e. interest-only loans, adjustable rate mortgages, no cost refinance loans, etc.  The 40 year mortgage is one such innovation.

Characteristics Of A 40 Year Mortgage

40 year mortgages work exactly the same as their 30-year cousins.  They usually have a fixed interest rate and are amortized over their term, which most of the monthly payment going toward interest in the beginning and principal towards the end.  A 40 year mortgage will sport a lower monthly payment than a comparable 30 year mortgage with the same interest rate, but here’s the kicker:  since a 40 year mortgage is considered riskier than a 30 year mortgage, they carry a higher interest rate, wiping out much of the benefit of extending the term.  Thus, borrowers strike a pretty poor compromise.  The lifetime cost of the mortgage is much higher with the 40 year term, obviously, but the reduction in the monthly payment is pretty minimal, as well.

Here’s a chart that puts the relatively tiny differences in monthly payments between a 30-year and 40-year mortgage in perspective.

The 40 year mortgage does buy you a $111 reduction in your monthly mortgage payment, but costs a staggering $139,680 more in interest over the life of the loan.  Only you can decide if $111 per month is worth an extra $139,680 over 40 years, but to me it most definitely is not.

Should You Get A 40 Year Mortgage?

While I have no particular qualms with the 40 year mortgage per se (the 30 year standard is as arbitrary a number as 40),  its appearance is evidence that the “standard” for what is considered an affordable home purchase is slowly but steadily increasing.  I wouldn’t be the least bit surprised if 50 years from now the vast majority of mortgages in American carried a 40 year term.  What this means is that an increasing amount of the nation’s wealth will towards paying our collective mortgages and less towards more productive purposes.  Basically, this switch is nothing more than a massive wealth transfer away from ordinary Americans to the financial wizards on Wall Street it’s so fashionable to hate at the moment.

So should you get a 40 year mortgage?  My own opinion is that if you can’t afford a 30 year mortgage, you can’t afford the property.  However, if you have done the math and go in with your eyes wide open, there are certainly some instances where taking out a 40 year mortgage makes sense, especially for real estate investors.  Minimizing the monthly payment so you can afford a home you wouldn’t otherwise be able to afford is not such an instance.