Does A 40 Year Mortgage Make Financial Sense?

With interest rates nearing fourteen-year highs buyers are looking at all methods to help with lowering the monthly payment so they can buy a particular home.  Buyers mainly consider the monthly payment and how it will fit within their budget.  By spreading out that payment over a longer period the buyer can reduce the monthly payment.  Adding interest into the mix a 40-year mortgage may not be the best financial option for buyers considering the short-term monthly payment savings as this article explores.

Lower Payment?

Certainly a 40-year mortgage can offer a lower payment compared to a 30-year mortgage regardless of interest rate, but how much lower is it really?  Let’s take for example a $400,000 mortgage with a 30-year and 40-year term at a 7% interest rate.  At 30-years a $400,000 mortgage results in a payment (not including tax and insurance) of $2661.21.  At 40-years the mortgage payment is $2485.73 (also not including tax and insurance).  That results in a lower monthly payment for the 40-year mortgage by $175.48.  That is a modest savings in the monthly payment. 

Looking at the overall interest a homeowner will pay though can raise some concern.  The total interest paid for the 30-year mortgage is $558,035 over the life of the loan.  For a 40-year mortgage the total interest paid is $793,148.  The additional interest paid on a 40-year mortgage is $235,113.  If held for the full 30 or 40 years that is quite a bit of extra interest to be paid.  While the average time a homeowner stays in one home is about 13 years, that means the homeowner will not necessarily be paying the full amount of interest measured over the 30 or 40 years.  The amount of interest paid towards a 40 year mortgage will still be higher over that 13 year period.

Refinancing The Mortgage

Some buyers may be tempted to get the 40-year mortgage now to have a lower monthly payment with the thought that they can refinance later at a lower rate.  At that later time the hope is that the rate is lower and they can reduce the term of the mortgage to 30 years or less.  This thought process relies on the belief that interest rates will be lower and the home value will be equal to or higher than when first purchased.  The value may not be higher depending on when and where it was purchased.  If the home value is not higher than when purchased and the homeowner has not built up enough equity in the home, refinancing may not be an option.  With any mortgage the initial payments mostly go towards interest with a small portion going to principal.  As time goes on that payment split switches with more going towards principal.  Therefore, early on less equity is built up in the home and will be even more so in a longer-term mortgage.  For an example of how this works check out this 40-year mortgage amortization table.

Whether mortgage rates will be lower is another factor that can change the circumstances of refinancing.  As of the publishing date of this article mortgage rates are in the low 7% range.  On October 9, 1981 average mortgage rates were 18.63%!  The average mortgage rate since 1971 runs at 7.76%.  So current mortgage rates are still slightly below average.  Will they be down in the next few years?  It is possible but no one can know for sure.  So it might be wise for home buyers to not necessarily bank on refinancing later on with a shorter term mortgage with the expectations of a lower rate and/or having enough equity in the home.

Alternatives For Buying A Home With Lower Payments

Cash is always an easy way to buy a home and can help a buyer save time by taking out the lender of the process who can sometimes stop the purchase completely.  No lender involved means a buyer can close on their home without the need for multiple credit reviews as well as the underwriting review of the entire purchase itself.  Not everyone has the cash to put down on a house though so that strategy does not work for all.  The cash buyer can also take out a mortgage later on for the home and get some of their cash back.

Adjustable Rate Mortgage or ARM for short is a mortgage where the initial mortgage rate is lower than the typical 30 year fixed mortgage rate and locked in for a period of time.  The interest rate can be locked for 1, 2, 3, 5, 7 or some other number of years after which the rate will become variable.  The variable interest rate is based on some reference interest rate (like Prime Rate or short-term U.S. Treasuries) plus some premium.  Due to the risk of interest rate adjustments being taken on by the home buyer lenders are willing to offer a discounted mortgage rate upfront.

In the past home buyers were willing to buy a home using an ARM and then refinance to a fixed rate loan.  As interest rates were lower than the average this worked out for buyers.  No one can know where mortgage rates will go in this environment as due to a number of factors (both global and domestic) interest rates have needed to go up.  A buyer may end up in a losing bet if they
buy with an ARM hoping to refinance to a lower rate at a fixed term later on.  Additionally pricing in some markets is in question and in fact dropping.

Final Thoughts

A 40-year mortgage might reduce the overall monthly payment somewhat but over the long term will end up costing the buyer more in interest.  The current interest rate environment is different than in the past due to high levels of inflation.  Banking on interest rates coming down in the near future and taking out a high rate mortgage could lead to an unpleasant short-term outcome. 

Additional Resources

• How Does The FHA Adjustable Rate Mortgage Work? - Learn about how an FHA ARM works, about the maximum interest caps they can have and who should consider it.
• The Impact of Inflation on Real Estate - Learn about the impact inflation is having on real estate and what home buyers and sellers can expect in the near term future.
• The Federal Reserve Funds Rate and Mortgage Interest Rates - Learn what impact the Federal Reserve has on mortgage interest rates.

About the author: The above article “Does A 40 Year Mortgage Make Financial Sense?” was provided by Commercial Real Estate Specialist Paul Sian. Paul can be reached at paul@CinciNKYRealEstate.com or by phone at 513-560-8002. If you’re thinking of selling or buying your investment or commercial business property I would love to share my marketing knowledge and expertise to help you.  Contact me today!

I work in the following Greater Cincinnati, OH and Northern KY areas: Alexandria, Amberly, Amelia, Anderson Township, Cincinnati, Batavia, Blue Ash, Covington, Edgewood, Florence, Fort Mitchell, Fort Thomas, Hebron, Hyde Park, Indian Hill, Kenwood, Madeira, Mariemont, Milford, Montgomery, Mt. Washington, Newport, Newtown, Norwood, Taylor Mill, Terrace Park, Union Township, and Villa Hills.