Leondis: Resist the siren song of 40-year mortgage loans

Because of rising interest rates and higher home values, the monthly mortgage payment on a typical U.S. home is 62% higher than a year ago. So, it’s only natural to be looking for a way to cut costs. But if you’re borrowing money to buy a home and think the answer to a cheaper mortgage is a longer-term loan, like 40-years long, think again.

The idea seems simple enough – just extend the life of the loan to save on monthly payments and refinance as soon as rates drop enough to make it worthwhile. Plus, a 30-year mortgage is a bit of a misnomer, as no one really keeps the same home loan for three decades these days. So why not just go for 40 years? There are many reasons not to play with the terms.

First, the monthly savings are unlikely to be substantial. If you borrow $300,000 for 30 years at a rate of 5% that is fixed for the life of the loan, your monthly payment will be about $1,610, according to calculations from HSH.com, a mortgage website for consumers. Assuming the same rate for a 40-year fixed mortgage (which is generous because the rates for 40-year mortgages are likely to be higher), the monthly payment will be about $1,447, a savings of $163.

Sure, every little bit counts at a time when home affordability is the lowest in decades, meaning that the median household income is below what’s needed to qualify for a mortgage to buy the median-priced home. But not so when accounting for the extra interest you’ll be paying. In just five years, you’ll have paid about $3,700 more in interest with a 40-year loan than one for 30 years and owe about $11,000 more because less of your payment with the 40-year will be going toward the principal amount borrowed. And if you do end up holding the loan for the full 40 years, you’ll pay $115,000 more in total interest than if you had gone with the 30-year loan.

And that’s why some lenders will gladly arrange a 40-year loan for you if you ask. They’d love to cash in on another product that could seemingly make a house more affordable because it would help to generate additional revenue. That’s especially true now as mortgage activity has plummeted this year.

It’s not like you’re going to be able to borrow a lot more with a 40-year loan. Assuming an income of $150,000 and all other things being equal, a longer-term loan increases the amount you can borrow by about $40,000, according to the HSH calculator.

Perhaps the biggest red flag with a 40-year mortgage is how slowly you’ll build equity in your house since more of your payment is going toward interest than principal compared to a loan with a shorter term. That may become an even bigger issue if housing prices continue to slow or even dip as we enter a housing recession.

Remember, you’re typically required to have 20% equity in your home before you can refinance to a lower rate or adjust the term of your mortgage. Most people put down a lot less than 20%, and may not be able to reach that threshold as quickly as they thought with a 40-year.

If you’re concerned about your monthly payment being too high, there are other ways to reduce the cost, such as paying points to lower the rate, making a larger down payment, or even considering an adjustable-rate mortgage. Ultimately, though, if $200 a month is making or breaking your ability to buy a house, you probably should reconsider.

Right now, 40-year mortgages aren’t backed by Fannie Mae or Freddie Mac. That means they aren’t guaranteed to have the same consumer protections that come with conforming loans, such as a limit on excessive fees. Given that you’ll have to go to an online lender, or a smaller bank or credit union to get one, the rate may not be that competitive either.

Earlier this year, the Federal Housing Administration, which backs loans for first-time buyers, said struggling homeowners could modify their existing home loans into ones with 40-year terms. (Fannie Mae and Freddie Mac also have an option that allows for existing loans to be modified into a 40-year repayment plan). Some viewed that as a sign the federal government might move to back the loans given how unaffordable homeownership has become.

Extending the loan term to 40 years may be helpful for someone whose alternative is losing their house, but given the mountain of interest and slower pace for building equity, I can’t see why endorsing a 40-year mortgage for new homeowners would be a constructive move for anyone other than the banks.

Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she oversaw tax coverage for Bloomberg News.