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Pros and Cons of a 40-Year Mortgage

Source: The Toronto Star

The 40-year mortgage is popular with homebuyers, especially in Toronto where prices have risen sharply. Let's look at the pros and cons of extending a mortgage past the traditional 25-year limit.

Harriet and Henry are buying a home in the Greater Toronto Area. They both have RRSPs, from which they plan to borrow $40,000 for the down payment, and parents who can make up the difference. The average home in the GTA sold for $380,000 last month. So, this couple puts down $76,000 (or 20 per cent) to avoid paying a costly mortgage insurance premium. They shop around and get a five-year fixed mortgage term at 5.64 per cent with President's Choice Financial. Here are arguments in favour of a longer payback period:

You can qualify for a bigger house with a lower income. Mortgage lenders want to see a maximum of 32 per cent of gross income going for mortgage payments, property taxes and heating – and no more than 40 to 42 per cent of income going for total debts. If Harriet and Henry have too low an income – or too much other debt – they won't be approved for a mortgage without stretching out the repayment.

You don't have to wait for your salary to go up. Waiting can be risky. You may cool your heels for five to 10 years before qualifying for the home you want. By that time, you may find interest rates are higher than they are today. And you will be closer to retirement. Let's say Harriet and Henry are in their early thirties when buying their first house. They have at least 25 to 30 years left in the workforce. But if they're 40 or more before they can buy a home, they won't likely pay off their mortgage before they retire.

You have more cash for living expenses. If your mortgage costs are punishingly high, you may have little left for other payments. Harriet and Henry have a $304,000 mortgage. They pay $1,880.44 a month with a 25-year amortization. But with a 40-year amortization, they pay $1,583.45 a month, cutting their monthly payments by $296.99 – or almost $3,600 a year. They have more cash flow to pay for property taxes, utilities, repairs, insurance, transportation – and yes, maybe even a holiday or two.

Here are arguments against a longer payback period.

You pay more interest over the life of the loan. With a 25-year amortization, Harriet and Henry will pay $564,131.35 in total (assuming they renew every five years at the same interest rate). They will pay a whopping $760,061.81 if they take 40 years to pay off the mortgage.

Let's look at the cost of interest alone. With a 25-year amortization, it's $260,131.35. And with a 40-year amortization, it's $456,061.81 – or half as much again as the initial loan. You build equity more slowly and get back less of the money you paid in when you sell the house: Suppose Harriet and Henry go for a 40-year amortization. A decade after buying a home, they still owe $276,589.17 on their $304,000 loan. After 20 years, they still owe $228,783.96. And after 25 years – when others have paid off their mortgages in full – they still owe $192,856.70.

So, how can you avoid this trap? Increase your mortgage payments as much as you can. Throw any other cash you have (such as income tax refunds) into the mortgage. Your goal is to shorten the payback period and interest paid – and to fatten your own bottom line instead of the lender's.

Posted on Friday, May 16, 2008 at 01:47PM by Registered CommenterElaine in | CommentsPost a Comment

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