I have found myself increasingly educating my clients and answering questions about the 40 year mortgage. Below I have listed my views on the 40 year mortgage, and also some links to articles on 40 year mortgages. I hope you find this informative and please feel free to forward this to anyone you know that might benefit from this information.
The primary benefit of the 40 year mortgage is the increase in cash flow, as your monthly mortgage payments are smaller. This allows people to purchase properties that they would not have considered if the 25 year mortgage was the only option. The following example shows how much a 40 year mortgage can decrease your monthly payments:
John and Jane Doe buy a $400,000 house in Annex (what a deal!!) at 5% interest rate, zero down payment with 25 years amortized and 40 years amortized comparison. Calculations provided below are for accelerated bi-weekly and monthly payment using RBC mortgage calculator. (https://www.rbcroyalbank.com/RBC:olbopda_fq/cgi-bin/mortgage/mortcalc.pl)
Over 25 years amortized:
Accelerated Bi-Weekly: $1,163.21
Total interest paid: $247,845
Total interest paid: $297,926
Over 40 years amortized:
Accelerated Bi-Weekly: $957.61
Total interest paid: $392,990
Total interest paid: $519,299
Difference in bi-weekly payment: $205.60 per month which translates into $2467.20 per year.
Difference in monthly payment: $411.20 per month which translates into $4934.40 per year.
The catch is that if you continue to pay according to this schedule, you will end up paying far more interest.
The way to beat the system:
1) Take advantage of your doubling up mortgage payment option and/or your annual pre-payment option of up to 10-15% of the total mortgage amount.
For the first couple years the idea is to have a lower mortgage payment, and free up some cash for other things. But as you earn more, you must take advantage of these options to pay down the principal faster. By reducing the principal, you will effectively change the interest paid, so that it reflects the interest paid on a 25 year amortization versus a 40 year amortization. The key is that you must reduce the principal so that the interest payments will accordingly be reduced. (http://www.rbcroyalbank.com/RBC:SAauCo71JsYAEAAaOmY/products/mortgages/money_saving_options.html for more info on payment options to pay down your mortgage faster)
2) Your pre-approval should be using a 25 year amortization to be really safe.
If you cannot afford the property on a 25 year amortization, then you may want to rethink buying it. Interest rates can change, and you should have some level of security. The 40 year can be used as an insurance policy in bad times, and use the double payment and pre-payment options in the good times. With any debt, one should always have some equity tucked away to account for the unknown. But, if you see future monies coming to you, then the 40 year can get you in the property while you wait for the new funds.
3) Use future increase in salary or receipt of funds.
If you decide to take advantage of this option, it is also important that you foresee an increase in salary or influx of funds in the future to take advantage of the payment options. If you are unable to do this, then you will be paying a staggering amount of interest in comparison to the 25 year.
Here are some links to articles I read on the 40 year mortgage with mixed reviews: