Given that it is an election year, I am reading more and more about housing affordability. As is inevitable, the 40 year mortgage is once again rearing its ugly head as a potential remedy. I am not sure that the payment savings is worth the increased risk to either the borrower or the servicer.

There is a large decrease in monthly payments from a 15 to a 30 year mortgage (27%); even given a higher expected cost of the 30 year. Extending the term to 40 from 30 years only
decreases the payment another 5% (see chart). On a $300,000 mortgage, this amounts to a paltry $96 per month.

Offsetting that, however, is that the borrowers’ equity build-up in the property drops precipitously over the first five years as the term is extended. This is due to a larger and larger percentage of each payment going towards interest as the term is extended. At the extreme, the “perma-debt” example above shows zero percent of the payment going to principal.

Our nationwide data shows that the peak of defaults is in year five. Absent any change (up or down) in the real estate market, a loan originated at 90% LTV (i.e. 10% equity) will build to 29% equity by the 60th month for a 15 year. The 30 year only increases to 15% equity, and the 40 year further reduces that to 13% equity.

Mortgagors often complain that they can make payments for years but see very little impact on their outstanding balance. A 40 year mortgage will exacerbate that. The optimal mortgage, from my perspective, when weighing payment affordability and equity build-up, is the 25 year mortgage.