Are 40-Year Options on the Horizon and Do They Make Sense?

By Douglas Katz – 07/06/2022

Last month, Housingwire reported that FHA was considering adding the 40-year fixed rate mortgage to their modification options.  While not yet a reality, this does bring up the question of whether we will see this product as an option beyond modifications for FHA as well as part of the conventional loan landscape.  Many, including The Mortgage Bankers Association, Housing Policy Council, National Association of REALTORS and the American Bankers Association support the proposed move by FHA, but is this a good product.

First and foremost, you need to remember that this is not a new loan offering.  They waned in popularity as rates dropped and shorter terms became available at affordable payments, but, like adjustable rate mortgages, longer terms fixed rate loans become popular as costs of ownership increase.  It is the same phenomenon that you see with financing cars at longer terms to afford one.  Unlike cars, however, homes work a bit different and a longer mortgage actually makes sense a lot of the time.

To understand how a 40-year or longer term is a good option, you must understand a few key concepts:

  • More Disposable Income Means Greater Flexibility – 40-year loans will have a lower payment than alternative which provides more disposable income.  You can use this for everything from investing to servicing other debt.  With a lower payment, you can choose where the income goes based on your needs.  This is especially true if you are tight in covering all of your expenses and if there is the possibility of negative changes to your household income.
  • Your Finances are Interrelated – Dovetailing on the above concept, you only have so much income.  When financing a home, many people silo the home without considering the rest of the picture.  While a 40-year loan means more interest and a longer loan term, it allows you to maximize that income.  If you have a credit card with $10,000 on it at 18%, you need to pay that down.  Accelerating paying down your home while leaving the higher cost debt in place means you are illogically using your income.  If you can pay 5% on your home and have 18% outstanding somewhere else, you should always use the assets for high interest debt first.  The same goes for investment when you can make more money by buying stocks, bonds, etc. instead of into your home.  I explain this concept a bit more in a later bullet.
  • Equity vs Appreciation – Equity is the difference between what you owe on a home and its value.  It is part of your wealth and net worth, but it is not as simple as you might think.  Your equity is comprised of the the amount that you put down when you bought the home, the amount that you have paid down and the appreciation.  Appreciation is the gain that you realize as your home increases in value, while the other components of equity are more or less a redirection on funds into the home.  You are not making any money with the down payment or debt service, but rather parking it in the home like forced savings.  APPRECIATION IS THE ONLY WAY THAT YOU MAKE MONEY ON YOUR HOME.  To calculate it, take your purchase price which was your basis and subtract it from the price.  The value will determine your gain (appreciation) or loss (depreciation).
  • Leverage vs Debt – Under both if these, you owe somebody money, but that is where the similarities end.  Leverage is typically using an asset as collateral to free up funds for a better use.  In the case of a home with a mortgage, it allows you to make the most of your cash flow for other purposes, like investment.  Now I know that many people have a mortgage because they cannot plop down the full amount at time of purchase, but that is not the point I am making and actually it is more about what mortgage.  Remember, there are a lot of choices and sometimes people choose a shorter term or pay down aggressively to have no loan.  They also lose a benefit gained by leveraging the property.  Debt on the other hand is just owing someone money.  This is oversimplified, but it is usually referring to what you owe on non-appreciating assets like a car or your credit card debt.
  • Opportunity Cost – This is a fancy way of saying that there are better and worse places for your money to help your financial picture.  Generally, you want to out as much money as possible somewhere where you can realize the greatest gain, such as 401K, IRA, etc.  Remember, servicing the debt on a loan is not investing and provides no gain.  Often times there are better places than your home for your resources and the opportunity cost is what you lose by putting it into your home.  Also, it is not the payment and interest but rather the difference between the interest.  If you are paying 6% and making 8%, your true realized return in 2%.  If you pay down your loan you are losing the ability to make that 2% on the funds that you are putting into your home.
  • Accessing Equity is ONLY Possible Through Debt – I often use the example of a stranded runner in baseball to clarify this for borrowers.  Like a stranded runner, your equity is stuck in the home until you access it and doing so is a similar movement of funds to paying down.  It is just in reverse, but unlike making a payment, there is a cost of doing so.  This actually erodes your wealth.  It is like when you get hit hard with ATM fees to get your money.  It is costing you to get your money making it worth less and refinancing is like doing this on a large scale.

So, if you understand these concepts and the genuinely accepted strategy that you want to maximize the gain on your money to get the best return, the 40-year makes sense.  The main reason for this is that your payment will be less and you can use it for anything from debt service to investment.  If that is not convincing enough, I would share with you what wealthy people do.  I did a lot of lending in the high-net worth segment and I can tell you many clients who could pay cash for expensive properties rarely did.  They leveraged the property by getting a mortgage and they kept investment intact and earning return instead of stranding that money.  I was once told by someone that freedom is not the absence of a mortgage, but instead it was the ability to pay yours off tomorrow.  The 40-year mortgage is a great example and I hope we see it soon.