Mortgages are a debt instrument that are secured by the collateral of real estate property. There is a set of predetermined payments that the borrower is obliged to pay back.
The main aim of a mortgage is to allow businesses and individuals to be able to purchase a real estate property without having to pay the entire amount up front. The next set of years are then spent by the borrower paying back the amount owed to the lender with interest until they are the sole owner of their property.
However, there are times when a regular mortgage might not be enough. And this is where a jumbo mortgage comes in.
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What’s a Jumbo Mortgage?
A jumbo loan is a kind of mortgage that is used when a property is too expensive for a conventional conforming loan. The limit for a conventional conforming loan has been set by the Federal Housing Finance Agency (FHFA). If you have a property that exceeds the limit set for a conventional conforming loan, it will require a jumbo mortgage, also known as a jumbo loan.
There are tougher qualification guidelines set for a jumbo mortgage and would require you to pay more than you would for a conventional home loan.
How Does a Jumbo Mortgage Work?
Jumbo mortgages have been specifically designed to finance luxury properties and homes in real estate markets that are highly competitive. They come with unique underwriting requirements and tax implications. However, these are the types of mortgages that have gained popularity as the housing market recovers from the Great Recession.
The value of a jumbo mortgage can vary state by state. The conforming loan limit size for different areas is set by the FHFA on an annual basis, though it does change frequently.
There is a different set of provisions by the FHFA for areas outside of the continental United States for loan limit calculation. Thus, as a result, the baseline limit for a jumbo loan is higher in counties that have higher home values.
If you want a home that costs close to half a million dollars or more and you do not have that much laying around, you are probably going to require a jumbo mortgage. And while you try to get one, you will have to face aggressive credit requirements than you would have faced if you were a homeowner applying for a conventional loan. This is because jumbo mortgages tend to carry more credit risk than conventional loans do for the lender since there is no guarantee by Fannie or Freddie. And of course, more money involved means more risk.
The minimum requirements for a jumbo mortgage have become stringent since 2008, much like traditional mortgages. In order to get approved, you are required to have a stellar credit score which should be 700 or above along with a very low debt-to-income (DTI) ratio. This ratio should be closer to 36% and under 43%.
Even though jumbo mortgages are nonconforming mortgages, they still fall within the guidelines set by the Consumer Financial Protection Bureau and are considered a “qualified mortgage” i.e. a lending system that has standardized terms and rules.
Jumbo Loan Requirements
If you decide to opt for a standard 30-year fixed rate mortgage, you will have to prove that you have accessible cash on hand that can cover your payments. You should be prepared as these payments are likely to be very high. Income requirements and reserves depend on the size of the loan but all borrowers need to pay 30 days of stubs and W2 tax forms that stretch back to two years.
For people who are self-employed, the income requirements are even more: two years of tax returns and at least 60 days of current bank statements.
To qualify, the borrower also needs to have provable liquid assets and cash reserves that should equal to six months of mortgage payments. All applicants are encouraged to show proper documentation on all other loans they might have as well as proof of ownership of non-liquid assets.
Jumbo Mortgage Benefits
The main benefit of a jumbo mortgage for a borrower is that they are allowed to go outside of Fannie and Freddie limitations. Which means you can get a competitive interest rate and finance the home you want without being restricted with a jumbo mortgage limit that conforming mortgages have.
Jumbo mortgage rates tend to fluctuate and can either be higher or lower than a conforming mortgage rate. They can also be a convenient way to finance property.
Jumbo mortgages also eliminate the need to get two conforming loans in order to finance a home. However, some borrowers prefer that they finance more of the home’s cost than tie up cash which can end up making jumbo mortgages a useful financial tool.
However, like all things, there are some jumbo mortgage pros and cons.
Jumbo Mortgage Drawbacks
Since jumbo mortgage loans are huge loans with high amounts, there is greater risk to the lender in case of a default. And when there is a risk to the lender, the interest rates are always high. This is the case for a jumbo mortgage as well that has higher interest rates than conforming loans.
However, once the loan balance has been paid below the Fannie and Freddie conforming loan limit, jumbo mortgages are free to be refinanced.
Moreover, jumbo mortgages also have strict underwriting requirements such as high financial reserve requirements and a low maximum DTI ratio a borrower is allowed to have.
Who Should Take Out a Jumbo Loan?
Your assets, credit score and the value of the property you are buying are what ultimately decides how much you can borrow. A jumbo mortgage is deemed most appropriate for people who have high incomes and make between $250,000 and $500,000 a year. This segment of high-income earners is known as HENRY which is an acronym for high earners, not rich yet. These are the people who, even though make a lot of money, do not have millions in extra cash or other assets yet.
Even though a HENRY individual may not have the wealth to purchase an expensive new home with just cash, they tend to have good credit scores and a more established credit history than an average homebuyer seeking a conventional mortgage loan would have.
These individuals also tend to have established retirement accounts and have been contributing for a longer period of time than lower-income earners.
Individuals in the HENRY segment are the kind of individuals that institutions love to sign up for long term loans. This is partly because institutions need additional wealth management services. Plus, it is just more practical for banks to administer a single $2 million mortgage rather than 20 loans valued at $100,000 apiece.
However, just because you may qualify for this type of loan does not mean you should take one out. And if you are seeking to get a substantial tax break then a jumbo mortgage would not be the best idea for you.
It’s common knowledge that you are allowed to deduct the mortgage interest you have paid for any given year from your taxes. All you need to do is make sure that you have itemized your deductions. However, you might never have to worry about the cap the IRS places on this deduction which was eventually lowered by the passage of the Tax Cuts and Jobs Act. If you got a mortgage in December 2017 or earlier, you can deduct interest on up to $1 million in debt which is what the old cap amount is. However, if you made any purchases after December 2017, you can only deduct the interest on up to $750,000 in mortgage. You would not get a full deduction if your mortgage is larger. To find out how much you can get in deductions, it is advised to use a jumbo loan calculator available online.
So even though you are, hopefully, now clear about what’s a jumbo mortgage, you can take better care when borrowing. And before you do that, it is advised to crunch the numbers carefully to see what you can and cannot afford. You can also find out what kinds of tax benefits you can receive, if any. The general rule is, if the property is highly taxed and expensive, it will always cost you more to own. Especially with a jumbo mortgage since the bigger the loan amount, the bigger the risk which leads to higher interest rates.
The best strategy you can have in cases like these is to compare terms to see if taking out a conventional mortgage or a second loan instead of one jumbo mortgage might end up proving better for your finances in the long term.