The 30-year mortgage that is now the gold standard of American home finance was once virtually unknown. In the early part of the 20th century most mortgages in the U.S. were “term” loans, mortgages that lasted just five years. Since most of the debt could not be repaid in five years, at the end of the term owners would go out and get replacement five-year mortgages.
This system worked fairly well until the 1930s. Then the Depression drove down employment levels and shredded property values. In the west, the Dust Bowl impacted many states.
But then a new idea arose. The just-formed Federal Housing Administration (FHA) said it would guarantee the repayment of 20-year loans if borrowers would pay insurance fees. Private lenders followed with their own longer-term mortgages and the result was that term loans largely disappeared from the U.S. marketplace.
Over time the accepted definition of “long-term” financing changed from 20 years to 25 years and then to 30 years. Forty-year mortgages have been available since at least the 1980s.
What’s the attraction of long-term loans?
Fixed-rate, long-term financing represents stability. If times are tough you don’t have to worry about qualifying for a new loan. And if rates are fixed, then rising interest levels are not a concern.
But longer-term loans also have another value: They may allow borrowers to qualify for more financing.
Suppose we want to borrow $300,000 at 6.5 percent interest. With fixed-rate financing, the monthly costs for principal and interest would be as follows:
Monthly Mortgage Payments: Principal & Interest
15-years: $2,613.32
20-years: $2,236.72
25-years: $2,025.62
30-years: $1,896.20
40-years: $1,756.37
50-years: $1,691.15
The list above plainly shows that the longer the term, the lower the monthly cost for principal and interest. The practical advantage of longer monthly payments is that borrowers can obtain larger loans. Compared with 15-year financing, using a 50-year loan would reduce cash costs by more than $900 a month in our example.
Monthly payments are not the only consideration, however. Borrowers should also look at potential loan costs. Because longer-term loans are, well, longer, money is outstanding for a greater period of time than with 30-year financing. The result is that potential interest costs increase substantially with time.
Total Potential Interest:
15-years: $170,397.98
20-years: $236,812.66
25-years: $307,686.45
30-years: $382,633.47
40-years: $543,057.81
50-years: $714,690.40
The huge interest-costs over 50 years surely seem formidable, but is that really the case?
There are several issues to consider.
If you can buy an appreciating property then a long-term loan may be advantageous when compared to the alternative: No financing. If you cannot qualify for other loan products because the monthly cost is too high or for other reasons, then 40- and 50-year financing may be attractive.
If you get a fixed-rate mortgage you have protection against rising interest costs. In effect, a hedge.
If you expect your income to rise in the future, a longer-term loan may allow you to buy now instead of waiting until you have a larger paycheck — or waiting until prices are higher.
If you have a fixed-rate mortgage and have the right to prepay, in whole or in part, at any time and without penalty, then you have two attractive options: First, as your income grows you can make monthly prepayments that reduce the loan term and cut potential interest costs. Second, if rates decline you can refinance — an attractive choice given that loans today can often be refinanced without the need for much (or sometimes any) cash at closing. (That’s not to say there is no cost to close, but that you can finance closing costs and thus avoid the need to come up with cash.)
This is the biggie: The potential cost over 50 years is not a worry if you only have the loan for five years, 10 years or whatever.
Would I get a longer-term mortgage? Actually, I have.
Long ago I bought an investment property with a 40-year loan. Since then rental rates have increased and the property has long thrown off a positive cashflow each month. No less important, the value of the property has increased some 400 percent — value I would not have if the property could not have been purchased.
So the next time someone mentions a longer-term loan, don’t laugh. Check rates, terms and conditions; it may well be that a long-term loan is what you need to get the property you want with the income you have now.
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Peter G. Miller is a syndicated real estate and personal finance columnist who appears 70 newspapers.
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Tags: 50 year mortgage, mortgage financing, mortgage trends