Perils of the 40-year mortgage

April 10 2008 by Ellen Roseman

Canada’s housing boom continues to roll along. We’ve avoided the U.S. real estate bust so far. But how long can prices keep growing?

Mortgages with longer payback periods (30, 35 and 40 years) are very popular with buyers. They bring down your monthly payments and let you get into the real estate market sooner or afford a bigger, better house. Now it’s clear that the extended mortgage has extended Canada’s housing boom.

Check out this report today by the TD Bank, Canada’s Red Hot Real Estate Markets to Cool. Here’s the key part:

The rate of increase in prices has exceeded the growth in household income, with the result that national housing affordability has deteriorated significantly.

The weakening in affordability is not consistent with a continuation of the price and sales growth that was experienced in 2007.

Why didn’t real estate conditions cool sooner? in our opinion, some of the new financing arrangements may have delayed the impact.

If there’s a real estate slowdown coming soon, how will it affect those with 40-year mortgages? They’re building equity at a glacial pace — and since many start with only 5 per cent down or nothing down, they could easily end up owing more than their homes are worth.

When I expressed concerns about long-payback mortgages yesterday, my column had the highest readership of anything published at TheStar.com. And, of course, many readers had their own views of this trend to lending liberalism.

29 comments

  1. Brian Poncelet, CFP

    Apr 10 2008

    Hi Ellen, you made some good comments about the 40 year mortgages. Here are some other thoughts.

    Back in 1990, a $100,000 mortgage at 12% cost about $1,053 per month P&I (amortized over 25 years). Today, a $200,000 mortgage @ 5.8% over 40 years is about $1,073 per month, P&I. Almost the same payments for double the mortgage! This real estate market, I think, is partly driven by cheap money.

    The big concern is with almost no real savings, people can leverage into their house like never before.

  2. Louis

    Apr 12 2008

    One cannot look at this as a short-term investment and expect to make a killing in a year or two. Most people have a home they live in for more than 25 years. The amortization time is not the important issue. The long-term accumulation of price increases is.

    The average price for a home in Toronto in 1982 was $95,496, while 25 years later in 2007 it was $376,236. Even during the downturn in 1996, prices still averaged $198,150. Forgetting inflation, which affect everything, the average person cannot get this type of return with virtually no up-front dollars -you can even get a mortgage with $0 down.

    This may be forced savings, but given most people’s starting point, it generates quite a return in the long term. However, short-term speculators may get hurt.

  3. Will Ashworth

    Apr 13 2008

    I have mixed feelings about the 40-year mortgage. I do think it provides homeowners greater flexibility in their financial planning, not less, as many comments seem to surmise.

    My biggest problem with 40-year mortgages is the price support it puts on current housing. Without borrowers’ ability to buy more house, prices would be dropping. Instead, they continue to move up.

    Eventually, the musical chairs will stop. Who’ll be left holding the bag?

  4. brad

    Apr 14 2008

    My problem with a 40-year mortgage is that it encourages people to buy before they’re ready, or perhaps before they should. The widespread belief that “if you’re renting, you’re throwing money away” creates pressure for people to buy, even if they only plan on staying in their new home for five years or less.

    With a 40-year mortgage, those people are still throwing money away. The only difference is that they’re throwing it away to a bank in the form of interest, instead of a landlord.

    Furthermore, at the end of five years, they’ll be worse off financially than if they were renting, because they’ll have had to pay for repairs and maintenance that would have been taken care of by a landlord if they were renting. And they’ll have virtually no equity unless they’ve been making extra payments toward the principal (which is unlikely, because most people who choose a 40-year mortgage don’t have enough cash flow to afford higher monthly payments).

    Presumably over the life of a 40-year mortgage, a homeowner’s earning power will eventually increase enough to allow him or her to pay off the mortgage early. But I think, in most cases, people would be better off renting until they can save at least 20 percent for a downpayment, and taking out the shortest possible mortgage they can afford.

  5. West Toronto realtor

    Apr 15 2008

    I think you hit the point about long term mortgages.

    I am working as a West Toronto realtor and I am trying to warn all my clients about possible risks.

    I think the main problem is just in the mind of the people. Once you are facing up to a life decision, you could be easily manipulated to buy a bigger house than you really need. Availability of long term mortgages could make it real, but nobody sees the risks.

    Just one for all: if you are now 30 and you’re considering taking a 40-year mortgage, you will pay till you’re 70 when you are already retired — and that could be a serious problem.

  6. JC

    Apr 15 2008

    Thank you Ellen for the insightful article on extended amortization mortgages. Like writer SS indicates above, these mortgages are not ALL bad. It is the manner of repayment that determines the effective amortization.

    For example, taking a 40 year amortized mortgage and making mortgage payments every other week (as opposed to monthly), the effective amortization drops to 31 years.

    If you apply your tax refund from RRSP contributions as a prepayment towards your mortgage each year, the effective amortization will fall well below 25 years.

    But let’s assume a change in circumstances — going back to school, taking time off to raise a child, whatever — and you can always fall back to the minimum payment.

  7. LM

    Apr 16 2008

    People should buy a condo in a high demand area, for which the payments are well within their comfort zone. They should pay it off as fast as they can, sell it and use the equity to buy a house.

    Even if the interest rates are higher, they will have at least $150,000 (after legal, moving costs, real estate commissions, etc.), so their mortgage will be manageable at their (higher) salary levels and will be paid off by retirement.

    The biggest problem people saddle themselves with is to go for the “picket fence” dream at all costs. A home doesn’t have to be a detached house. Many kinds of real estate can be a great investment.

  8. Ted Rechtshaffen, Tridelta

    Apr 16 2008

    I share your concerns on 40 year amortizations for the 30- year-old new home buyers trying to determine what they can truly afford.

    Having said this, we love 40-year amortizations and use them quite often for a completely different client segment.

    Increasingly, we work with clients who are 55+ and are real estate rich and relatively cash poor.

    Most of these clients are planning on selling their home at some point in the next 5 to 15 years. What they want is more money accessible now, while they are still healthy, so that they don’t have to dig deeply into their RRSPs and get taxed, or simply to enjoy their retirement without feeling like they have to watch every penny (or deciding not to take trips or help their kids because they think they can’t afford it).

    We would only use the CHIP Reverse Mortgages as an absolute last resort, as the rates and fees are outrageous.

    These clients aren’t interested in paying down debt. When they sell their house for $800,000, they are happy to pay off their debt at that time (whether it is $100,000 or $300,000).

    What they are essentially doing is shifting cash to themselves at a younger age when they can enjoy it, rather than having more cash for the last 10 years of their life when they may not be healthy enough to use it.

    A 40-year amortization mortgage provides the following to them:

    § Access to the very lowest borrowing rate possible

    § Lowers the cash flow required to pay back the mortgage

    If they could get a straight line of credit at Prime – 0.65%, they would do it. But in order to get this kind of rate, they go for a mortgage with the lowest monthly cash flow.

    In some cases a straight line of credit, slowly withdrawn, is the best solution. In others, because of tax deductibility and high dividend yields, it makes more sense to do a mortgage, invest it conservatively and draw down the cash as needed.

    This is just one type of scenario where someone is actually trying to take some equity out of their house and has no desire to pay down the debt, and a 40 year amortization mortgage is significantly better for them than one with a shorter amortization.

  9. CE

    Apr 16 2008

    Maybe homes are just too dammed expensive and way out of whack as compared to wages…they’re going down and housing is going up?

    All one has to do is read a newspaper outside of North America and one can see (even a blind squirrel can find a nut!) most European home prices are falling dramatically –England, Ireland, Spain and on and on, not to mention our
    southern friends.

    Why not report on that…the real estate industry doesn’t have the guts to do that!! Even more amazing, when they do appear on TV, how one could easily call it lying. And the only ones who believe it are the industry.

    A friend Realtor told me they received a request from the Ontario Real Estate Association for all agents to go out there and convince as many people as possible that the market is still OK.

  10. AC

    Apr 16 2008

    One disadvantage is that a 40-year mortgages may complicate retirement planning, and may require delaying retirement rather than being able to take early retirement.

    In my day, a 25-year mortgage (reduced to 20 years by paying 13 months per year via biweekly payments) meant being debt-free before retirement, including having a final few working years of putting away large sums for retirement.

    By stretching out the payments until past the normal retirement date, the homeowner has to plan to either (1) trade down the property, (2) sell other assets / dip into savings to pay off the mortgage, or (3) have a continuing high cash flow to service the debt. Options (2) and (3) make the homeowner prey to high-fee mutual fund hucksters, rather than have risk-free, tax-free returns from paying off the mortgage.

    On the other hand, for those expecting to receive a sizable inheritance before retirement, who have the discipline to put that money into paying down the mortgage, starting with a 40-year mortgage may not be too bad.

  11. RE

    Apr 16 2008

    Great article. Trouble is that the message will be lost on the majority of spoiled kids who think they are entitled to own anything they want, regardless of whether they can pay for it or not.

    Being an older guy, I was brought up to only buy what you could afford today, and if you had to use credit you kept the payments at a level you could afford, which meant you often had to choose a lesser house or a less sexy car.

    Trouble is that the kids today fail to realize they have no RIGHT to own anything they cannot afford.

    The bottom line is that when the con men make it possible for people to buy more than they can afford, we all suffer.

    Just think of the subprime situation in the USA. People who had no right to own a home were allowed to get one. When they defaulted in huge numbers, everyone in the WORLD is effected. Why should my retirement income, that I saved for years to build, be reduced because some US criminals figured out a scam to give people a house they had no right to have ??

    40 year mortgages are just another example of such a scam.

    Lots of people will say such mortgages are necessary because of the cost of houses. Bottom line is, from the percentage of income point of view, things are no different today then when I entered the work force over 40 years ago and started to save towards my first house.

    Within a few years, I had the required 10% down and the income to afford the standard 25-year mortgage payments (this is the standard that should be used to evaluate if you are capable of affording the house).

    One way to get more people into a home is to get the builders to build smaller and more affordable homes. Many years ago when I moved into Mississauga, you could buy a house which was 1/2 finished inside.

    The first floor had one bedroom, a bathroom, a kitchen and living/dining room. The upstairs was roughed in for 2 more bedrooms and a bath, to be finished by the owner when he had the funds and time.

    My house across the street sold for 54k (which I could afford), while that smaller house was about 30k !!

    I guess the spoiled brats of today would never consider such an option, but I know those who owned these places now have moved up to much better homes and are living a comfortable retirement with no debt !!

    In the end, as long as we have people who think they are “entitled”, we will have con men who will arrange some way to get these weak people into more debt than they can afford.

    Trouble is that those who are not bright enough to do the basic calculations will end up broke at retirement and will moan and groan about how their situation is someone else’s fault !!

  12. JSF

    Apr 16 2008

    Most of us have seen the 5 to 7 year cycles in the housing industry, followed by a 6 to 10 month slump as the market saturation works its way out of the surplus. The recovery starts with starter homes and ends with a flurry of high end custom luxury homes.

    This is natural, because the industry’s capacity catches up with demand and saturation is reached at some point.

    What has happened in the US is that the normal cycle has been extended by incentive lending practices, and so in fact, the market is overbuilt, relative to the normal cycle, and instead of a short slowdown, the catch-up is severe.

    This is what I forsee here, since we have had a very long extended high level of house building activity, which these no-downpayment CMHC-insured mortgages are allowing. At some point, where price acceleration will cease and prices will adjust downward, people will find that their mortgage will be higher than the house value and will just walk out.

    This happened in the late ’80s, if I remember correctly, and the banks became the largest homeowners in the country. This time it will be CHMC.

    The above situation will make the situation worse and more severe, and the recovery be will vastly longer than it would otherwise take.

    I appreciate your comments about the mess this situation will cause by the banks pushing affordability, but wait till house prices go down, and they always do at some point, until a correction takes place. Remember, housing activity is a cyclical phenomenon.

    I worry about the long-term implications, and the pain it is going to cause to the overall economy.

    In the US, Congress is talking about rewarding those that caused the problem – what a mess.

    Thank you for showing the reality of the situation. Greed will win out for a time, unless common sense is legislated.

  13. DL

    Apr 16 2008

    Scary stuff.

    One of the easiest way to bring down the balance would be to always match the payments to the paycheque. (i.e. if you get paid biweekly, pay the mortgage biweekly, if you receive a wage increase, increase the payment amount).

    For us, lump sum payments were hard to come by, but increasing the payment amount twice per year was a major help reducing the balance.

    What we encountered when we were first starting out was that the mortgage bank staff had precious little idea about the length of the amortization period and would generally suggest the longer term, smaller monthly payments. It was an eye opener at the end of the first year of payments (at 13%….) that we owed more than we started with.

    I started using the amortization book to see how much we could afford and brought the length of term down with each renewal.

    Different times then, our first town home in Markham was less than what your article subjects paid for their down payment. Best decision we ever made to buy then, should have bought two…

  14. Peter Mose

    Apr 22 2008

    Greatly enjoy your columns. You’re one of the best reasons to read the Star!

    I’m stymied by your recent railing against either longer-term or interest-only mortgages. I write you as a low-income piano teacher, not as a finance sophisticate, never mind someone in the housing or banking industry.

    In your Harriet and Henry column the other day, you neglect a few obvious parts of the profile, which I would appreciate your adding to the mix the next time you mention this assumedly delightful young couple.

    Here’s my take….

    1. Harriet and Henry are very possibly going to part ways long before either 25 years of a traditional mortgage period or 40 years of a new-style longer amortization roll around. We don’t expect couples to stay together, whether married or common-law. So Harriet and Henry need help now, getting a Toronto house for the next few years that we assume they will remain together.

    2. People uproot every few years, even if they stay together. Harriet and Henry are almost certainly not going to remain in their $380,000 GTA house forever. So once again, the 25 years vs. 40 years is sort of a meaningless fiction.

    3. If Harriet and Henry in their early 30s each have managed to save at least $20,000 in RRSPs, that means they are people comfortable with the concept of saving and investing. Good for them.

    So why not assume that they will preserve this mindset? In other words, let us consider that they actually invest the $3600 a year they will save by electing a 40-yr. amortization over a 25-yr. one. It should not be difficult for them to get a better return than the 5.64% rate of their mortgage, even as conservative investors, so they are ahead of the game.

    4. Moreover, should they experience financial reversals some time during their life together, Harriet and Henry would be better off having less money locked up in their home as equity. Because that would be equity money they cannot readily access, unless they sell their home.

    5. If by some strange twist of fate Harriet and Henry actually do stay together for a long lifetime, they will probably be able to pay off their mortgage before year #40, with the money they have made as conservative investors, abetted by salary raises, inheritances, etc. Or they may choose not to do so, and to continue investing and shooting for higher returns than the rate of their mortgage. With mortage rates very low, this would be the prudent course, in my opinion.

    6. If home prices in Toronto were not stratospheric, I might be more inclined to agree with your conservative thinking. But a Toronto Star yuppie journalist couple who want to live in a trendy area like Leslieville or Parkdale will be forced to spend easily $500,000 for their small starter home. Help from their folks or not, that’s still a staggering half-million dollars. (Financially, they would be much better off trying to find jobs as journalists in Buffalo or Rochester, where real estate prices are more reasonable — but that’s another story.)

    Or they can buy a small condo for $250,000-$300,000, and face monthly condo fees and taxes of perhaps $1,000. I’m not sure they would be ahead. Probably about the same monthly outlay, though arguably a less good investment than a house.

    7. You have made no mention of the all-important concept of financial diversification. If Harriet and Henry have most of their money tied up in their home — i.e., in real estate — that’s not considered good financial planning. It’s extremely common, I grant you, but it’s certainly not heeding the principle of diversification.

    8. My point in all of this is that longer amortizations have a place, just as do interest-only mortgages. That’s if you accept the premise that people in Toronto should become home-owners if at all possible. Renters unfortunately retain a second-class status in this town. But of course renting forever would be another legitimate way for Harriet and Henry to conduct their lives.

    They might actually be better off as renters, and at least not get themselves in over their heads as readily as they might by taking on a mortgage in overpriced Toronto, whether said mortage is 25 years or 40 years.

    Thanks for reading these thoughts your column sparked.

  15. JC

    Apr 25 2008

    Hi Ellen (and Angie AS) – just a few thoughts. If I ready your circumstances correctly, you would be putting less than 10% towards your purchase, you would likely sell the house after 2 years, and your sister is a real estate agent. First, I would ensure that the mortgage you get is either fully open, or at least open after 2 years to avoid a penalty. Second and more importantly, if you do in fact amortize the mortgage over 40 years, the CMHC premium will amount to 3.35% of the loan amount – almost $6,000. So unless you port this cmhc insured mortgage to a subsequent home, you will not recoup this significant cost.

    Finally, and somewhat unrelated, taking a 40 year amortized mortgage and making payments on an accelerated bi-weekly basis results in an effective amortization of 31 years.

    Keep up the great work Ellen!!!

  16. Tami

    Feb 8 2010

    If renting a small apartment is no cheaper than buying a nice house, then the 40 year mortgage does make sense. I can say that from experience.

    We needed a home and we looked at apartments and they were small, with horrible air circulation, no privacy etc. The cheapest price for one was $650/month, and if you wanted one that actually looked nice inside and was renovated, it would be at least $1,000/month, heat and lights not included.

    We bought a beautiful split level 3 bedroom home with water view and it only costs us about $1,300 a month with property tax included. Once our big bills are paid off (student loans, car) and the 5 year fixed rate is up for renewal, we will change it to a smaller amortization loan.

    For people just starting out who are smart with their spending, they will make the most of the 40 year amortization. It’s not forever, or at least it doesn’t have to be.