What Are The Benefits Of A 40-Year Mortgage Amortization?
If you have ever borrowed money to buy a home, then you are probably aware of the 30-year and 15-year fixed-rate loans. But what about the 40-year loan?
When it comes time to borrow money for the purpose of buying or refinancing a home, borrowers today have numerous options. While you do not have a lot of control over the mortgage interest rate that you will be charged, you do have the benefit of multiple choices on the amount of time you take to repay the loan.
Today, we're going to examine three different repayment periods including a 40-year amortized loan to see how the time you choose to satisfy the loan impacts the benefits that you receive.
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What Is Mortgage Loan Amortization?
When you borrow money from most banks or mortgage lenders, they provide you with a principal and interest payment that you agree to make each month for an agreed-upon period of time. This "amortization" of the loan ensures that they get the interest that you agree to pay for the entire period of time that your loan has an outstanding balance, while you get a payment that does not change during that same time frame.
For most of my career, lenders typically offered a 15-year amortization and a 30-year amortization on their loan programs. Occasionally, we might see a shorter term, but recently, we are starting to discover longer amortization opportunities.
For this reason, we're going to do a simple case study that evaluates a 15-year, 30-year, and 40-year amortized loan to see if the "new" 40-year amortization is something our buyers might want to consider.
Choosing A Loan Example
In order to conduct a side-by-side analysis of three different loan amortization periods, we need to make some simple choices and assumptions to get it rolling. The purpose here is not to create a science experiment that conclusively identifies every aspect of the decision-making process, rather it is to show the impact that changing the amortization period will have on relevant issues to homebuyers today.
For many buyers, the amount of the monthly mortgage payment is the most important issue of all, so I am going to start there. Afterward, we'll look at how the loan balances change over time, the rates at which equity growth occurs, and then we'll conclude with a simplified ROI analysis to provide some insight that many buyers would not consider.
Finally, you should also consider the length of time you plan to own the home when making your choice. You don't need to lengthen or shorten the period of time just because you plan to move sooner or later, but you might want to ensure you choose a repayment plan that will have you in an equitable position prior to the date that you believe you will be moving.
Our example is going to be built around somebody buying a $400,000 home with a 5% down payment ($20,000). This will result in a loan for $380,000 that the buyer can utilize a 15-year amortization, a 30-year amortization, and a 40-year amortization. In order to determine the rates to use for each loan, I went to the internet on November 12th, 2021 and determined the prevailing rates from reputable sources.
I found the 15-year loan was 2.25%, the 30-year loan was 3%, and I estimated the 40-year loan to be 3.25%. These will work fine for our example, but you will want to know current rates the day you need to make a decision. Most likely, a borrower will be offered rates that are the lowest for the 15-year amortization and the highest for the 40-year amortization.
The principal and interest portion of the monthly payments are as follows:
- 15-year amortization: $2,489
- 30-year amortization: $1,602
- 40-year amortization:$1,416
As we see from above, the longer the amortization period, the lower the monthly principal and interest payment. This makes perfect sense, as a forty-year repayment stretches the principal requirement far longer than do the thirty and fifteen-year loans.
It's interesting to see that the 40-year amortization is roughly $1,000 less per month than the 15-year amortization (and why it might be so popular with many buyers today). But as we follow with our analysis, we'll find that the lower payment does come with a price.
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How Loan Balances Change With Different Amortization Periods
Our first graph plots the loan balance over time for each amortization period.
All three graphs in today's report run for the first ten years of the loan's life. The horizontal axis shows the year number (every two months) for every point in the graph. Three green lines provide the results for the 15-year loans, the blue lines provide the results for the 30-year loans, while the red lines show the same for the 40-year amortized loans.
A fifteen-year amortization period lowers the loan balance far faster than do the 30-year and 40-year amortized loans. The extra $1,000+ paid each month with the payment is the reason we see the results above.
If the payment amount does not scare you and you favor repaying the loan as soon as possible, the shortest amortization period is your best option.
Home Equity Is Different Too
This next graph has quite a few calculations occurring behind the scenes. It accounts for the downpayment made when the home was purchased, the appreciation the home has gained (calculated at the home value increasing at 5% each year), the closing costs paid when the home is sold (8% of the future home's value), as well as the principal reduction from each monthly mortgage payment.
This graph is very similar to the first one, as the primary difference between the three results is the pace at which the borrower is repaying the loan. Again, we see the short amortization periods resulting in more equity in the home because the borrower has "put" the equity in through the form of repaying the outstanding balance.
The first two graphs have made it clear that if you want to owe less on your home and have as much real estate equity as possible, take on the shortest amortization period that you can handle. But there is another factor that you might want to consider.
ROI When Choosing A Loan Amortization Period
While people do not buy homes solely (or primarily) as investment vehicles, I like to encourage them to see the economic opportunity that a home provides. One way to do this with our example is to conduct a simplified ROI analysis for the three different loan amortization periods.
The graph above was created by analyzing each month's equity versus the amount of money paid thus far by the borrower. I call this a "simplified ROI" because I have not accounted for the time-value of money, rather I used a simpler formula of ROI = [(Equity-Investment)/Investment)]. Simply put, what did they put into it and what did they make? The "investment" includes their downpayment as well as their principal and interest payments.
Here are some observations from the graph:
Take the results here more from a relational basis as opposed to an absolute one. I have not attempted to determine a fair and absolute ROI, rather I have attempted to compare the ROIs of each amortization period.
It takes until year four for each of the two longer amortized loans to have positive equity, but it happens in year three for the short amortized loan. This means that the ROI is negative for a period of time before it turns positive and is negative longer for the longer-term loans.
The ROI calculation does not include closing costs of buying the home, nor does it include the taxes and hazard insurance premiums being made. I have to mention these because they are real costs. Again, this is a relative comparison to analyze the impact of different amortization periods and these costs would be fairly constant across each period.
The 15-year amortization in our example delivers the best bang for the buck if you hold the home for 8 years or less. If you hold the home from 8 to nearly 15 years, the 30-year amortization delivers the best ROI. But if you plan to own longer than 15 years, the 40-year amortization delivers the best ROI. And this is the point that I wanted to discover. You should consider your expected holding period when deciding on the amortization period for your loan.
Equally as important, I am advising homebuyers that they will likely own this home far longer than similar buyers would have held it when we look over the past fifty years. Home affordability is going to tank, and it's likely that a major portion of would-be move-up buyers is going to have to stay put. That means the mortgage loans being borrowed today will have much longer shelf lives than their counterparts from the previous fifty years. If you want to better understand this point, you should read this article and watch the accompanying video.
Right now, mortgage interest rates are near historic lows, and many borrowers can leverage lower rates and longer terms to strengthen their financial positions. If you have debt on anything beyond your home, your home mortgage (most often) is the last of all debt to satisfy as it likely is the lowest after-tax rate that you pay.
When it comes time to choose a mortgage amortization period, make sure you ask your lender for all the options for which you qualify. You'll want to know the rate and terms for each.
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