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November 8, 2004
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 � % higher on 40-year than on 30-year mortgages. With a
�% 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 � %
higher, the reduction falls to 1%.
30-Years With a Residual Balance Is 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 is not outstanding for as long. Further, 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.
Is a Residual Balance Loan the Same as a
Balloon Loan?
The astute reader will realize that what I am
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 have a reason for giving it a
different name.
Existing balloon loans have a term of 30
years, with the balance due after 5 or 7 years. They are viewed as close
substitutes for adjustable rate mortgages (ARMs) having initial rate periods of
5 or 7 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 is
not 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.
15-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. 15-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, 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, and it has a slightly longer duration. These might
call for a rate about � % higher than on the unmodified 15. But that would still
add up to a dynamite product for the borrower.
Copyright Jack Guttentag 2004
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