Mortgages: Monthly Payments vs. Loan Term Length

Here’s a quick graph that I didn’t include in my previous post on choosing between 15, 30, or 40-year mortgages

I’ve always felt that loan lengths were a bit arbitrary. Why did 15-year and 30-year loans become the industry standard? It’d be just as easy to make a 25-year mortgage. So I took a step back and compared term length vs. monthly payment for a $300,000 mortgage at 5.5%. The result was interesting, and I would think the general behavior should be consistent across different loan amounts and interest rates:

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The graph shows that mortgage payment stops decreasing very much as the term goes past 20 years, and really starts to flatten after 30 years. If you use the 30-year as the benchmark, the 20-year payment is 20% higher, while the 40-year payment is only 9% less. Stretching even further from 40-years to 50-years only saves you another 5%.

Given this information, you’d think that having to get a 40-year mortgage should be a sign that you really can’t afford that house. Yet according to Bankrate, 25% of all new mortgages in California are 40-year mortgages (nationwide it’s more like 5-10%). This is partially due to the fact that pseudo-government Fannie Mae buys 40-year mortgages now. In fact, the mortgage industry has already rolled out 50-year amortizations for certain adjustable-rate mortgages. The next few years for housing should be really interesting…

Comments

  1. I thought it was just a reflection of how expensive the local market was. Just as you point out 25% in California versus 10% or less in the rest of the country use 40 year mortgages. Similarly, friends of mine in London say 99 year mortgages are how they afford to live even near the city.

  2. I suppose this is obvious, but of course the limit (as n goes to infinity as it were) of this idea is interest-only loans.

  3. JimmyDaGeek says:

    I think there is a more practical reason for standardizing on a 30 year loan. This time period would pace many peoples’ working lives. Before they retired, they would make sure to have their mortgage paid off. It used to be more difficult for older people to get a mortgage because of concerns about being able to make the payments if they couldn’t work anymore. When most banks still owned their mortgages, they certainly did not want to have to deal with foreclosures.

  4. The graph would flatten out even more if you took into consideration the lower interest rates available for shorter term loans. It also shows that you can pay your mortgage off 10 years early by increasing your P&I payment by 20% each month.

  5. Ted Valentine says:

    A 50 year mortgage? That’s like renting, but you get to assume the risk of property devaluation. What’s the point?

  6. I still think getting a 40 or 50 or 99 year mortgage is better than paying rent every month. At least you get some equity and you have the option to pay it off faster as your income goes up. Plus, rent will go up every year but with a fixed rate mortgage, your payment stays the same.

  7. You could make a case that 40 and 50 year mortgages allow homeowners and investors to leverage their investments longer and preserve the value of the mortgage-interest deduction over a longer period of time. Of course, the interest rate on these products is likely to be higher so who knows what the math would work out to. My gut instinct tells me that, like most other exotic mortgage products, a 50 year mortgage is probably appropriate for a very small percentage of a specific group of buyers and nobody else. But like Kevin above said, the graph would probably look quite different if you took interest rate differences for the various terms into account. I’d be interested in seeing a graph using current rate quotes from bankrate.

  8. 50 year mortgages. I hope not. You would have to buy a house when you are 15 to have it paid off by the time you retire! Goodness, people really don’t plan ahead do they?

  9. It’s a matter of time Mom.
    There are 40 year loans now. I’m willing to bet there will be 50-60 year terms in my lifetime.

    Remember, you can get a 7 year car loan now.

    saladdin

  10. Scott, it’s 99 year leases, not mortgages. That’s generally for a leasehold on a flat, where someone else owns the land and the building (freehold). When it comes to SFHs, it’s usually 20 or 30 year mortgages. My inlaws, who are English, thought we couldn’t afford our home because we got a 30 year mortgage. Back in their day 20 years was the max. I guess things change.

  11. It would be interesting to know how long these loans are actually held, and if that differs by term length. I suspect that very few people today own a home for 30 years, or even 15 years. If you own the home for only 5 years, the long term loan becomes nothing more than an expensive rental payment.

  12. The term is only a number — if it helps someone get into a house affordably and they really want the house, then why not? 40 year term – 50 year term … Even if you paid off your house in 10 years, you will still owe taxes, insurance and utilities on it for the rest of your life (or the time you live there). The mortgage amount is just one more number that becomes increasingly insignificant as time goes by. And if you do sell it, then the money comes right off the top and you are rid of the 40 year albatross.

    The only time there is a problem is if you have a crummy mortgage with pre-payment penalties — or the equity in the house declines and you owe more than it’s worth. But that would be a problem with a conventional mortgage anyway.

  13. I believe the average maturity of mortgage loans ends up being around 7 or 8 years before people either sell or refinance. Put that way, the term really only determines how much principle you would have paid off over that period of time. Taking out a 50 year loan doesn’t necessarily mean you’ll be paying on it for 50 years.

  14. There are 40 year loans now. I’m willing to bet there will be 50-60 year terms in my lifetime.

    As was stated before, Interest Only loans are infinite-year terms, so you’ve already seen where this goes. Hell, negative-amortization loans are even worse (sort of, they always limit out).

    I believe the average duration of a home loan is under seven years, so banks expect few people to hold the loan to maturity.

  15. But interest-only mortgages don’t let you actually wait for infinite years until payoff, or pay interest indefinitely. They are still usually based on a 30 or 40 year amortization. The interest-only portion only lasts about 5 or 10 years.

  16. moneyandpf says:

    Thanks for plotting out this info on a graph. It’s much easier to look at things this way and gives you a feel for what the difference really is.

    Jonathan,

    Are you still leaning towards a 30yr fixed?

  17. OK, this chart seems to suggest it’s better to get longer terms than shorter since you really don’t save much monthly anyhow. The reason for that is no one actually live through the whole loan term. If someone stayed in one house from the day they bought the house till they die (and paid off), it’s going to be some very rare occasion (but still does happen these days.) I mean, most people live in one house for 5-7 years then move on to some other place.

  18. btw, in Canada, 20 year mortgages had been the norm for a long time. also, they don’t have title insurance there — you go to the land registry office and whatever they say, goes. you get a copy of their printout showing that there are no pre-existing liens on the property, and you’re free and clear to sell the property. also, all capital gains for residents are tax-free, period, no weird rules about 2 years out of 5 ownership.

    of course, in Canada there is more regulation of the whole home-buying process, there is even a so-called “Crown corporation” CMHC (kinda like the quasi-private/govt enterprise that Fannie Mae and so forth pretend to be) that actually seems to be helpful to creating fully informed consumers. for example, there’s data about regional and national housing trends:

    http://www.cmhc-schl.gc.ca/en/corp/about/cahoob07/index.cfm

    they even let you manipulate all that data the way you like! for free. that’s tax dollars at work!

    why buy in this country again?

  19. arz – I don’t think you’re correct. No matter what the term is, the payments would never be below $1,375 a month (Limit of the payment as the term approaches infinity). All you’re doing then is paying an interest-only mortgage for an infinitely amortized term. The longer the term of your mortgage is, the higher the interest-to-principal ratio will be. The interest-to-principal ratio will approach infinity as the term approaches infinity, meaning you’ll never see the amount owed decrease.

    Jonathan’s right: There isn’t anything magical about a 30-year term. What’s the best way to mathematically optimize the loan? Well, not having one (paying cash) would mean that you aren’t paying one dime of interest. However, it also means that you paid a steep opportunity cost by not using that cash on something else, when you could have ostensibly had a loan for 6%. Thoughts?

  20. Naveen, only if you can accumulate equity against interest, but since most people sell their homes in 5-7 years, they don’t accumulate much equity anyhow. The longer you stay in a home the better to get the loan shorter.

  21. Focusing too much on the monthly payment is part of the reason the mortgage industry is in such trouble. If you can’t afford the 15, but you can afford a 40, then maybe the house is out of your price range. The size of homes today relative to family size is ridiculous. Too many new home buyers are trying to buy their dream house on a 30 or 40 year mortgage. Instead buy a much cheaper house, build up some equity, and buy another house in 5 years. You can continue to move up in house throughout your life and build some wealth over time.

    Most people on this blog realize there are better ways to build wealth outside your home, but that takes discipline that most people don’t have. With the savings rate at historical lows, the majority of low-income and middle class families would be better off with short-term mortgages.

  22. The monthly mortgage payment is the boogie man for most of us .. credit card delinquency; repossessed cars, etc… don’t carry the stigma of a foreclosed home.

    “putting a roof overhead and food on the table…” is a deep-seated worry – so taking a longer (30yr) mortgage with a lower per month payment and tucking away cash in an emergency fund to cover 1yrs payments let’s me sleep at night. When the e-fund spills over then I make that extra payment to the bank to pay down the loan. Bankrate’s calculator are very helpful to show how these periodic (even if small payments) help in the long run

  23. JimmyDaGeek says:

    One fact that has been left out of the discussion is that lenders increase the interest rate of longer term mortgages. Interest-only loans would have the highest fixed rate, although the only loans I have seen are ARMs.

  24. This is truly an eye-opener. I know a few people that think they’re getting a great deal w 40-yr mortgages right now. I agree with the notion these folks probably can’t afford what they bought.

  25. 30/40/50 years… Nowadays, how many times people moving from one place to another? Me, from GA, to NY, then to DC. Buying a home, forget about it…

  26. Maybe here is the solution. They should reverse the rate structure such that a longer time period has a lower rate. This would make owning a home more affordable and 40-50-60 year mortgages would make more sense. Call you Congressman, see where that gets you.

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