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Jack M. Guttentag The Mortgage Professor

Perspectives on the 40-Year Mortgage

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Very Good (90 Ratings): 3.52222222/5

Posted on Tuesday, February 13, 2007, 12:00AM

Is the 40-year mortgage a useful instrument?

I don't think so. While 40-year mortgages increase affordability by reducing the mortgage payment, the reduction is very modest. Furthermore, a small tweaking in the 30-year mortgage would accomplish the same thing, maybe better.

The impact of an extension in term on the mortgage payment is smaller the longer the initial term. At 6% interest, extending the term from 10 years to 20 reduces the monthly payment by 35.5%. Extending it further to 30 years reduces the payment by 16.3%. And going to 40 years reduces it by only 8.2%.

Even 8.2% is an exaggeration, because lenders will set a rate at least .25% higher on 40-year than on 30-year mortgages. With a .25% increment, the payment reduction falls to 5.3%.

If market interest rates escalate, the bang from going to 40 years weakens even more. At 10%, for example, going from 30 to 40 years reduces the payment by only 3.2%, and if the 40-year is priced .25% higher, the reduction falls to 1%.

A Better Option

If you take a 40-year loan of $100,000 at 6%, your payment is $550.21, and after 30 years you still owe $49,553. A 30-year loan could be written for the same amount and rate, and with a payment of $550.21, provided that a balance of $49,553 was payable after 30 years. This could be called a "residual balance mortgage."

The 40-year loan and the 30-year residual balance loan amortize in exactly the same way. The only difference between them is that in the second case the balance after 30 years must be repaid or refinanced.

This should make the residual balance mortgage more attractive to lenders because of the shorter duration -- their money isn't outstanding for as long. Furthermore, the lender is advantageously positioned to solicit a new loan from the borrower at the 30-year mark. These advantages should translate into a better rate than for the 40-year loan. Few borrowers will or should concern themselves with the prospect of having to refinance after 30 years.

The Same as a Balloon Loan?

The astute reader will realize that what I'm calling a 30-year residual balance loan is the same as a 30-year balloon loan with a term of 40 years. That is, the payment is calculated over 40 years but the balance must be repaid after 30 years. I've got a reason for giving it a different name.

Existing balloon loans have a term of 30 years, with the balance due after five or seven years. They're viewed as close substitutes for adjustable rate mortgages (ARMs) having initial rate periods of five or seven years. The major difference is that the balloons have no caps on the interest rate change at the end of the period.

A balloon mortgage on which the balance isn't due for 30 years, however, is for all practical purposes a fixed-rate mortgage (FRM), since very few borrowers will have the mortgage for 30 years. Because it will appeal to a different type of borrower, and because lenders will price it off other FRMs rather than off ARMs, it deserves a different name.

Fifteen-Year Loans with a Residual Balance

The residual balance loan has even more potential as a modification of 15-year than of 30-year loans. Fifteen-year loans carry a significantly lower rate than 30-year loans, but most borrowers can’t afford the payment.

For example, a $100,000 loan for 15 years at 5.375% has a payment of $810.47, compared to $599.56 on the 30-year at 6%. But a 15-year with a residual balance of $58,173 would have the same payment as the 30-year, making it affordable to a much larger segment of the market.

From the lender’s perspective, the 15-year with a residual balance has a little more default risk because it amortizes more slowly than the standard 15-year, and it has a slightly longer duration. These might call for a rate about .25% higher than on the unmodified 15-year. But that would still add up to a dynamite product for the borrower.

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9 Comments

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John - Thursday, June 7, 2007, 11:59AM ET Report Abuse
- Overall: 1/5
The BEST Mortgage is owning a house free and clear- NO MORTGAGE PAYMENT! Or at least paying it off in 1/2 to 1/3 of the usual term! What really made a difference to us is by getting on the program through United First Financial. We just got on their program and we have all our credit card debts paid off and are now set to pay our 30 year mortgage off in half the time! This actually is an interest cancellation program that is helping us save almost $200,000 off our mortgage & basically USE THE BANK'S MONEY INSTEAD OF THEM USING OUR MONEY!! We build up equity each month and we don't have any lifestyle changes- no extra payments out of our pocket or anything like that. It really works! We watched the vidoo on this website www.u1stfinancial.net/johnfechik and filled out the financial analysis on the website to see if we fit the criteria- not everyone does- but our financial future looks great now & I can finally sleep at night NOT worrying about how we will ever get out of debt!! If the President made it a law for all homeowners to get on this program, we could have America on the road to recovery soon with all the debt we have burdening us!!
CarlB - Tuesday, March 27, 2007, 8:11AM ET Report Abuse
- Overall: 2/5
This article was written by Guttentag in 2004. Google it. To answer the reader's question about residual loans, specifically regarding the 15 year, I have no idea what he is talking about. Maybe he means a 15 year ARM? Never heard of one of those, either. Residuals are exactly what they sound like. Money due at the end of the term. On a 15 year loan (I have one) you get equity very fast. Drive a lousy car and put your money into your house. If you calculate how often you buy a new car, how much you put into gasoline, repairs, downpayments, etc, you will find it to cost darn near as much as your house. YIKES!
Jack Heismann - Sunday, March 18, 2007, 6:28PM ET Report Abuse
- Overall: 1/5
Bad Advice. Follow it, and you just might find yourself homeless and broke after 30 years. If you can't afford a traditional 30 year mortgage, and choose a 40 year deal instead, you're locked in at $550.21 every month for the full 40 years. If, at the end of 30 years, you have money in the bank, you can easily pay off the $49,553 balance, own your home outright, and have the equivalent of a 30 year "residual balance mortgage" (also called a "balloon" mortgage). But, if you make the mistake of going for the 30 year "residual balance mortgage" from day one, here's what happens. At the end of 30 years, you're stuck. You owe the bank $49,553, and you have to come up with that cash somehow. Great if you have money in the bank. Great if interest rates are really low. But if you don't have the cash, if times are tough, or interest rates are sky high, you might find that you can't pay the bank, can't refinance, and just like sub-prime borrowers today, have no way out. Yes, Virginia, the bank could grab your home, just when you were hoping to retire. Sure, that $49,553 won't be worth as much 30 years from now but why would anyone take that kind of chance, when you can get the same deal with a 40 year mortgage with no pre-payment penalty (pretty common today). Take the advice and try a 30 year "residual balance mortgage"? You'd have to be nuts to go for that deal.
Yahoo! Finance User - Friday, February 16, 2007, 5:37PM ET Report Abuse
- Overall: 2/5
1) Can someone explain what a Fifteen-Year Loan with a Residual Balance is? 2) Is there such thing as a Ten-Year Loans with a Residual Balance? 3) I actually meant to rate this as a good article as opposed to fair but I am having some browser issues.
Mr-showme/oddtodd40us - Friday, February 16, 2007, 11:28AM ET Report Abuse
- Overall: 1/5
I think that the mortgage and loan industries are nothing more than legal loan sharking! you buy a home for 250,000.00 when you pay off your fixed loan you will have payed at least 4x its original value all i can say is do the math minus your escrow account and see for your self, i'd say more but not enough room however i'll be finishing a book about how I feel about this industry hopefully by next year!

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