Gee it seems like only yesterday that we were talking about the newest innovation
in mortgages - the 40
year loan. Actually it wasn't exactly yesterday, it was January, 2005 and
the 40 year loan term wasn't exactly new, it had been around since the record
high interest rates in the 1980s without ever achieving any real acceptance.
But last year Fannie Mae announced a pilot program to test-market a 40 year
product throughout the country. Today approximately 5 percent of new mortgages
in the country are written for a 40 year term.
Now the newest wrinkle is, are you ready for this - the 50 year mortgage?
This isn't exactly a reflection of the fact that we are living longer but rather
a reaction to skyrocketing housing prices and the slow upward creep of interest
rates.
As with many an over the top idea, the 50-year loan originated in Southern
California where several banks rolled out the product in March. It is generally
offered as a variation on the 5/1 hybrid adjustable rate mortgage
where the initial rate is fixed for five years and then adjusts according to
a predetermined index (commonly the London Interbank Offered Rate or LIBOR.)
The concept is simple - string out the time required to pay back money loaned
and the payments will be smaller. In a market where traditional mortgage payments
are freezing people out of homeownership each such innovative program will allow
another sliver of those shut out to qualify for loans. Banks are marketing them
as a less risky alternative to the popular interest only or
option
mortgages as the loan does amortize so that the homeowner builds limited
equity. The lenders expect them to be particularly popular with homeowners who
have been making only the minimum payments on their option mortgages and are
getting a little panicky as their rate adjustment date nears.
Longer term mortgages also have some significant advantages for the lender.
While it is probably a safe assumption that not many borrowers will hang around
to burn their mortgages in 2056 - most will be too old to manage the match
- some will, and this smoothes out the lender's cash flow and lowers
the cost of advertising. Every business person knows it is cheaper to keep an
existing customer than woo a new one.
According to Bankrate.com about 25 percent of new mortgages
in California are 40 year loans so the 50 year home loan "is the next step."
One banker says he has taken over 200 applications already for the new product.
Perhaps the 50-year will have little appeal outside of California but let's
take a comparative look at the various terms of mortgages that are out there
and what each will cost a consumer who takes out a $200,000 loan.
The 15-year fixed rate mortgage is currently priced at 6.17 percent. This would
require a payment for principal and interest of $1,706.14 and would cost the
borrower a total of $107,104.77 in interest over the life of the loan. At the
end of five years the borrower would have a balance remaining on the loan of
146,898.49, a substantial accumulation of equity during the period.
The 30-year fixed rate mortgage this week carries a rate of 6.58 percent. The
same $200,000 loan would result in a payment of $1,274.68, a savings of $431.46
each month over the 15-year each month. This loan if kept for the full 30 years
will cost $259,502.57 and at the end of the fifth year has allowed the homeowner
to build $14,110 in equity.
The savings are not, of course, nearly as dramatic for the longer term loans.
Instead of doubling the amortization period the length of the loan is increasing
by 33 or 66 percent. Still there is a slight decrease in payments which may
be just enough to qualify a borrower for the size loan needed to buy the house
he wants. That decrease is only the least bit significant if one assumes that
the interest rate on a 40-year loan is close to that of a 30-year and that a
50 year hybrid will be priced the same as a hybrid with a much shorter
amortization period. This is probably a misleading assumption but we will come
back to that issue in a moment.
At the same 6.58 percent rate enjoyed by the 30 year mortgage the payment on
a 40 year mortgage (both fixed and variable rate products are available) will
be $1,182.33 or $92.35 less than the 30 year equivalent. The 5-1 hybrid is currently
priced at 6.22 percent which would result in a principal and interest payment
of $1,085.47, an additional $96.86 savings.
Over the life of the 40-year loan the borrower will pay $368,141.35 in interest
and have $6,790.09 in equity at the end of five years. The total interest
over 50 years is pretty irrelevant when it comes to a variable 50 year,
but we will assume no increase in interest rates over that long haul, thus making
it $451,869.40. The more relevant number for this loan is the equity at the
end of the first five years which will be a very stingy $3,828.87.
The upfront savings are not terribly appealing; the only real reason to take
a 40 or 50-year loan is if it qualifies a marginal buyer for a loan he/she could
not otherwise manage in the eyes of those writing the underwriting guidelines.
The real danger, however, is that a borrower could get trapped in the loan as
interest rates rise or equity does not.
While the longer term loans have certain advantages for the lender as stated
above, they carry a higher risk. The longer the loan the more
the opportunity for the borrower to get into trouble and default on the loan
and the greater chance that interest rates will increase substantially faster
than the index and margin on the loan, (and there are probably interest rate
caps as well) presenting the lender with a lot of lost opportunity. Therefore,
it is not reasonable to assume that lenders will be willing to price a 30-year,
a 40-year, and a 50-year loan at the same rate. There are currently 41 basis
points separating the 15-year and 30-year loans and we read that there is a
differential of around 25 basis points between a 30 and 40 year-fixed loan.
So we speculated that, because it is an ARM, 30 basis points would be a reasonable
differential between the current 6.22 rate for a hybrid 5/1 with a 30 year amortization
and a 50 year, resulting in a projected 50 year mortgage rate
of 6.52%. That would result in a payment of $1,180.47, a monthly savings of
only $94.24 over the 30 year fixed.
All of these numbers may have left your mind numb but if you have any thoughts
about taking out a 40 or a 50 year loan we hope you are clear-headed enough
to realize that these loans are not for everyone. The only possible excuse for
taking on such a burden is if it is the only way to qualify for the loan you
need and if you are absolutely certain you will be able to refinance or sell
your house within five to seven years. Well here is a suggestion.
Take out a smaller loan! There is an old expression about having eyes bigger
than your stomach when filling your plate - it works as well for buying a house.
If you honestly cannot qualify for a $200,000 loan for 30 years, then squint
and buy a house with a loan of $192,279. That will require a payment equal to
the $200,000 40-year loan or for $185,219 to for the same payment as a 50-year.
This will mean a smaller house or additional time to save up a larger down payment,
but it also means good financial sense in the long run.