Thursday, March 8, 2007

40-Year Mortgages

As home prices have risen in recent years, new strategies have emerged to help buyers afford a home. But one of these "new" strategies is really an old one that's returned to favor: the 40-year mortgage. A number of lenders offer them, but are they a good deal? Let's look at the pros and cons.

What is a 40-year mortgage?

A 40-year mortgage is a conventional mortgage, but instead of repaying the principal over the standard 15, 20 or 30 years (the amortization period), you pay it off over 40 years. In many cases, the lender simply extends the life of its 30-year fixed-rate mortgage to 40 years. Some lenders also offer a 40-year version of their adjustable-rate mortgage (ARM).

The advantage

The biggest advantage of a 40-year mortgage is that you get a lower payment. For example, the monthly payment for a 30-year, $100,000 mortgage at 6 percent would be about $599. By choosing a 40-year mortgage, you would get a slightly higher interest rate -- say, 6.25 percent -- but your payment would fall to $568.

That's not a huge difference, but it could be enough to let you buy a home you couldn't afford with a 30-year mortgage. Just a few dollars a month can be the difference between qualifying for a mortgage and not qualifying. A 40-year mortgage could also help you buy a higher-priced house for the payment you can afford, especially if mortgage rates are high. Or it could leave you more money for other expenses.

The cost

A 40-year mortgage also has some drawbacks. It carries a higher interest rate -- typically, .25 to .375 percentage points above an equivalent 30-year mortgage. And since you're making payments for 10 more years, you end up paying substantially more interest. Over 40 years, you would pay a total of $172,515 in interest on that $100,000 mortgage at 6.25 percent, compared with $115,838 for a 30-year mortgage at 6 percent. That's a difference of $56,677.

Another drawback is the speed at which you build equity in your home. With a 40-year mortgage, you will build equity much slower than with a 30-year mortgage, which means when you sell, you'll get back less of the money you've paid into the house. These mortgages might also tempt you to buy a bigger house than you can afford, so it's wise to make sure you're not biting off more than you can chew.

Does it work for you?

Despite its faults, a 40-year mortgage may still be a good option. If you're at an early stage in your career, it can allow you to buy a house you might not have been able to afford otherwise. As your income grows, you can refinance to a mortgage that lets you build more equity.

Remember, few people hold a mortgage to maturity. If, like most people, you move or refinance in five to seven years, the original 40-year term has little effect. And meanwhile, you've had the benefit of a lower monthly payment.

A 40-year mortgage can also be advantageous for high-income earners whose mortgage interest payments may be their only major income tax deduction. Or, it might reduce the carrying costs on a rental property.

There are other types of mortgages that can reduce your payments just as much as a 40-year mortgage. One alternative is an interest-only mortgage, which can give you a lower payment but builds no equity at all. Or you can choose a hybrid or regular ARM, both of which offer a lower initial interest rate but could expose you to rising rates later on.

How to choose?

Compare your payment, the interest you'll pay and the equity you'll build in the time you expect to be in the house. This will give you an idea of which mortgage is best for you.