High mortgage interest rates and high home prices have limited the number of people who can qualify for a home purchase loan. Although lending guidelines are for the most part set by Fannie Mae and Freddie Mac, the Federal Housing Finance Agency (FHFA) might be pressured by politicians to change standards and allow more people to buy.
Part of this “solution” could be to require the government-sponsored enterprises (GSEs) to purchase 40-year mortgages. But aren’t there already 40-year mortgages?
The most common 40-year term is a modification of a 30-year loan on which a borrower is unable to stay current.
For the purposes of this discussion, a 40-year mortgage is defined as a fixed-rate loan that is free from interest-only payments and a balloon payment. It has 40 years of the same principal and interest payments, just for different amounts than the traditional 30-year mortgage.
Although there are a few fixed-rate loans with 40-year terms at origination, the most common 40-year term is a modification of a 30-year loan on which a borrower is unable to stay current. The idea is that an extension of the term to 40 years lowers the monthly payment and enables the borrower to avoid foreclosure.
Foreclosures often end in a loss to the mortgage holder. Keeping a borrower in their home has both social and economic value. Recent borrower distress was to a large extent caused by the COVID-19 pandemic. In April 2020, there were 23 million people unemployed in the U.S. Forbearance programs prevented a major loss of homes around the country and have been praised for thwarting an economic catastrophe.
The GSEs offer a “flex modification” program, as does the Federal Housing Administration (FHA). This enables the extension of the remaining loan term to 40 years. The borrower gets to keep their house and the holder of the beneficial interest in the mortgage avoids any loss associated with foreclosure. Flex modification brings the mortgage current by adding unpaid principal and interest to the balance so that the borrower makes this up over time.
The fact that 40-year mortgages are for distressed borrowers invites a question: Why don’t we make 40-year mortgages available to people who, because of their debt-to-income ratio, cannot qualify for a 30-year mortgage but meet other criteria? An important issue is that a 40-year loan is not a qualified mortgage and is ineligible to be purchased by the GSEs.
For 40-year mortgages to be competitive, there must be many lenders willing to grant them. This is unlikely to happen unless they are deemed to be qualified mortgages. This would likely require the cooperation of FHFA, the GSEs and the Mortgage Bankers Association.
So, what are the advantages of 40-year mortgages? A lower monthly payment, for one. Also, some borrowers may only be able to qualify to purchase a home by extending the payments over 40 years.
But borrowers would face other problems. It might be more difficult to refinance or to get a second mortgage. Homeowners who finance over 480 months will see their equity build at a slower pace. And lenders would likely require a higher interest rate because the risk increases by adding 10 years to the term.
A Bloomberg opinion piece from last year criticized 40-year mortgages by making the argument that the monthly payment is not sufficiently lower than that of a 30-year loan. This misses the point that with home prices and mortgage rates where they are, some people cannot qualify for a 30-year mortgage because their debt-to-income ratio is too high. If a 40-year term enables them to own a home, there is little reason to criticize the longer term. Moreover, only a tiny portion of people who get 30- or 40-year loans keep them to maturity. The average life of a 30-year mortgage is eight to 10 years, with people usually refinancing or purchasing a new home.
This does lead to the question of why the 30-year loan has become the standard of the mortgage industry. Before the Great Depression, purchasing a home typically involved a 50% downpayment and a five- to 10-year loan with interest-only payments. At the end of the term, you had to pay off the balance or refinance.
When the Great Depression happened in October 1929, banks were unwilling to make any new loans and this led to an increase in foreclosures. In 1932, 273,000 people lost their homes to foreclosure. The next year, 1,000 mortgages a day were being foreclosed upon. In 1934, the FHA was created, which established fully amortizing, 15-year fixed-rate mortgages that eliminated the concern for what the final payment would be.
The 30-year mortgage was officially authorized by Congress in 1948 (for new construction) and in 1954 (for existing homes). With home prices and interest rates having increased dramatically in 2022, there is talk of having the GSEs buy 40-year mortgages. While this would enable an increase in homeownership, it also would likely increase prices since more people would be qualified to buy homes.
With high home prices and interest rates at their highest points in decades, 40-year mortgages deserve consideration. A mortgage with payments spread over 40 years would enable more people to purchase a home. It would require FHFA to direct Fannie and Freddie to create 40-year mortgage programs. And it would require that these 40-year loans are qualified mortgages.
There should be little doubt that a 40-year mortgage is good for some people. Unfortunately, these would affect the housing market and the GSEs. While 40-year mortgages may have political value, they also might be the path to another disaster for the balance sheets of Fannie and Freddie.
In the fall of 2022, the U.S. entered a market in which home prices started to decline in some areas. A significant drop in home values is a disincentive to people already having trouble with payments to keep making them. Across this group of people with a 40-year mortgage, there will be less equity in their homes. Those who are least invested in their homes may be inclined to walk away from the debt in times of trouble.
This time of trouble could be on the horizon. Ed Pinto, director of the American Enterprise Institute’s Housing Center, believes that U.S. home prices will drop by 8% to 10% year over year by August 2023. This is not a time for riskier mortgage standards. Modifications should be allowed for 30-year mortgages in distress, but the origination of risky 40-year mortgages is a step too far. ●