More on 40’s

Mortgage-Amortization In case you weren’t tired enough of the 40-year mortgage debate, here are a few final thoughts…

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People generally choose 40-year amortizations for three main reasons:

a) Flexibility (e.g. in case they lose their job and need to maximize their cash flow)

b) Investment benefits (e.g. better cash flows on income properties)

c) More buying power.

Reason C is the main point fueling the recent debate over 40-year ams.

Yet, it should be acknowledged that if 40-year amortizations did not exist most buyers would instead get the best homes they could afford with a 25-year am. That means:

  • They would still use the same 32-40% of their gross income towards housing.
  • They would still have the same approximate monthly payment

With a 40-year amortization, the difference is that they’d have a higher value home and pay down less of their principal each month. It’s clearly a personal choice on how to spend their money.

No matter what amortization is used, however, Canadian lenders will generally not allow borrowers to spend any more on housing than the standard debt ratios allow. The borrower’s income is the limiting factor, regardless of the amortization chosen. 

40-year amortizations were designed for people who can pay their bills. We have yet to personally see a lender approve an income qualifying mortgage where the borrower couldn’t afford the house. (Stated income may be a different case but that is another discussion.)

So the next questions are…

What effect do increased buying power and increased interest burdens have on our society?

If the net effect is negative, where do we draw the line? Do we outlaw interest-only lines of credit and high-interest credit cards? Do we force people at Best Buy to pay cash for their new plasma TVs? Do we stipulate in the Constitution how much Canadians are allowed to spend annually on interest?

These are not meant to be statements of opinion, but rather questions to ponder.

  1. I too am considering a 40 yr amortization but only if rates on a variable mortgage is the same as one on a 25 yr. We will be putting down the full 20% down payment as well. I intent to prepay on a schedule that would have the mortgage paid off in 15-18 years.
    The 40 yr amortization would give me that bit of insurance in case a job loss or other unforeseen hardship. However, if the rate is not the same as a 25 yr then I won’t touch it.
    One issue I have with the way 40 year amortizations are being marketed is the assumption that as your earnings increase you can afford to increase your payments and shorten the mortgage. How many people will actually have the discipline to do that, with their families growing and expenses increasing? Also, the bulk of the interest payments are in the first 5-10 years so if you don’t increase your payments in the early years you won’t be making much of a dent in that outstanding mortgage and hence not chopping a whole lot off your years left. I have the feeling many people stepping into 40 yr mortgages don’t realize just how much they’d need to increase their payments after 5 or 10 years of the minimum to actually make a substantial change in the years left in their mortgage.

  2. With 40 yr mortgages we are going to desaster and again the real problem is housing prize which is going only up.

  3. On a 300k mortgage at 5.6% the payments for 25 and 40 year amz are 1,848.68 and 1,554.62 respectively. lets say you lose your job. is 300 bucks per month going to make the difference between keeping and losing your house? The best advice is to keep $10,000 in a safe place for a rainy day. The difference in interest paid between a 25 and 40 year am is $200,000.
    If you don’t commit to paying down your mortgage (by getting a 25 year am) you probably won’t. You will get used to the payments and you will likely end up spending the excess money.

  4. People really need to think long and hard at the impact of having to pay a mortgage for 40 years will have on their needs down the road. For example, if you purchase a $300,000 home at 6% interest, you will have paid ~$485,000 in INTEREST for a 40 year amortization versus ~$275,000 if you choose a 25 year amortization. That’s over $210,000 more in interest for those 15 extra years. That’s almost a quarter of a million dollars lost in interest payments.
    In short, a home paid in 25 years allows you to have 15 years of mortgage free life and extra cash to spend on vacations, investments, etc… If the average person purchases his home at age 30, do we really want to be paying for mortgages until we are 70?
    Now, for some, the 40 year amortization could make sense if used to lower commitment costs. For example, my wife and I purchased a home recently and chose a 35 year amortization based on the fact that we are currently living on 1.5 incomes and wanted to make sure that we could afford the mortgage on 1 income. However, we fully intend to put well over $500 extra on the mortgage each month which would bring us in line with the equivalent of a payment for a 25 year amortization. You just have to make sure that the mortgage you choose has some prepayment flexibility.

  5. Folks, it is important to keep in mind the concepts of the “present value” and “nominal value” of money.
    The present value is the discounted cost of a nominal amount (ie actual dollars) paid in the future.
    So if one is paying $210k in extra interest (ie a nominal payment) over a 40 year period, then the true cost (ie present value) is not $210k but a much smaller amount.
    For example, $210k paid in level installments over the next 40 years is equal to a present value of approx $78k (at 6% interest).
    My post is not intended in support nor critique of any particular mortgage product, whether 40 yr am or otherwise.
    It just irks me when people ignore such basic mathematics.
    regards
    Simon

  6. Simon,
    I assume that the present value takes into account inflation and its effect on future values? How does it work exactly? I have to admit that I don’t know much in terms of calculating this so I’m sorry if I overlooked what you consider to be basic mathematics.

  7. Simon you may be right about the net present value of mortgage payments.
    Though you fail to mention the opportunity cost of choosing a 40 year amortization. That is, not being able to invest the extra money you pay in interest. For a fair analysis you need to do an NPV calculation on that foregone money as well. Then you must adjust for the interest made on the 40-year’s payment savings each month – assuming you invested the difference in payments between a 25 and 40 year amortizaiton.
    It is actually far from basic math but in the end you will find that you are effectively paying (losing) far more than the $78 in your example.
    Kevin

  8. I agree that the calculations may not be simple for many people. But the concept of present value versus nomincal value is at the core of any investment decision.
    To have an accurate picture then you have to also include:
    -Inflation
    ie. your future earnings will increase in step with inflation. Similarly, your future payments (both interest and principal) will be “devalued” by the amount of inflation. With inflation at 2%, this means that your house will become 2% more “affordable” each successive year
    -Lost/gained investment (aka opportunity costs/gains)
    You lose the gains on investing the extra interest on your 40 yr am, but you gain from investing your saved principal paydown (whether that gain is financial, or by virtue of luxuries like food and clothing ;-)
    Once again, I’m no morgage expert. Just making the point that the present value of money should be considered in any investment decision, the same as you would consider taxes, risk, and all other factors.
    Simon

  9. Sorry, one other thing to add…
    The appreciation of real estate is related to the cost of money (ie interest) which itself is related to inflation.
    Thus if one pays 6% on a mortgage, but the asset appreciates at 6% then the financial cost of servicing the mortgage is zero. On the flip side, if the house appreciates at substantially more or less than the mortgage rate then that can change the picture substantially.
    Just another variable to keep in mind.
    And again, I’m just a pleb who has stumbled across this site, so I claim no particular mortgage expertise.
    Simon

  10. Just to be clear on a discounted cashflow basis a 25 and 40 year mortgage have the same net present value. (hint the present value always equals the opening mortgage balance). if the interest rates, discount rate, and opening balance are the same the NPV will always be the same.

  11. John wrote:
    “On a 300k mortgage at 5.6% the payments for 25 and 40 year amz are 1,848.68 and 1,554.62 respectively. lets say you lose your job. is 300 bucks per month going to make the difference between keeping and losing your house? The best advice is to keep $10,000 in a safe place for a rainy day. The difference in interest paid between a 25 and 40 year am is $200,000.
    If you don’t commit to paying down your mortgage (by getting a 25 year am) you probably won’t. You will get used to the payments and you will likely end up spending the excess money.”

    Hi John,
    Thanks for the comment! You’re absolutely right about the need for an emergency fund. At the same time, $300 a month covers one extra payment every six months. Every little bit helps when your income falls off a cliff, especially when you don’t have much savings.
    We’ve found that most people are either disciplined or they aren’t. If they’re not driven to pay down their mortgage they often won’t even consider a 25-year am–despite us preaching otherwise. At least if they get into a 40-year with good intentions, it’s better than no intentions at all!
    I know what you’re saying though.

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