What is a Jumbo Loan?

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Definition:

A jumbo loan is a property loan that exceeds the maximum amount for a conventional conforming loan.

🤔 Understanding a jumbo loan

A jumbo loan is a home or property loan for an amount that’s greater than the maximum allowed for a conventional conforming loan — One that conforms to specific guidelines set by the government institutions Fannie Mae and Freddie Mac. Because jumbo loans do not meet these criteria, they aren’t guaranteed by the federal government, which makes them riskier for lenders. To account for this increased risk, lenders may require borrowers to meet more stringent approval criteria. In 2020, the maximum conventional conforming loan amount for one-unit properties is $510,400 in most counties and $765,600 in high-cost areas like California and Washington, D.C. A jumbo loan is any home loan that exceeds these amounts.

Example

Let’s imagine a homebuyer, Sarah, who wants to take out a home loan for $600,000. The home is not in a high-cost area, so the amount exceeds the maximum for a conventional conforming loan. Because of this, Sarah will need to take out a jumbo loan, which can’t be guaranteed by Fannie Mae and Freddie Mac. This is riskier for the lender, so it may require Sarah to have a particularly high credit score (over 700 or 720), a low debt-to-income ratio (below 42%), put down a bigger down payment, and to have cash reserves on hand, among other things.

Takeaway

A jumbo loan is kind of like borrowing your friend’s expensive sports car...

Your friend might hand over the keys to his expensive Lamborghini, but he’s going to need to feel very confident that you have a spotless driving record — If you ding up the lambo, it’s going to be a hugely expensive mess, and it may not be covered by insurance. Similarly, lenders may agree to let you borrow money for a very expensive house, but they’ll want to be completely sure you can afford it. Since those loans aren’t guaranteed by Fannie Mae and Freddie Mac, if you default on it (don’t pay it back), no one’s going to help your lender cover the cost.

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What is a Jumbo Loan?

A jumbo loan, aka a jumbo mortgage, is a home loan for an amount that is greater than the maximum amount allowed by the Federal Housing Financing Agency for a conventional conforming mortgage.

Typically, jumbo loans are used to finance luxury properties or homes within expensive housing markets.

Because these loans exceed the limits for traditional home loans, they aren’t guaranteed by Fannie Mae (the Federal National Mortgage Association) or Freddie Mac (the Federal Home Loan Mortgage Corporation) — That means that if the borrower defaults, the federal government won’t swoop in to save the day and pay back the debt.

To mitigate risks, lenders typically have more strict approval criteria for jumbo loans, which includes a higher credit score floor, higher income, a lower debt-to-income (DTI) ratio, and more cash reserves on hand, among other things.

Typically, jumbo loans also have higher interest rates, and borrowers are required to put down larger down payments. Some lenders require a minimum 20% down payment for a jumbo loan, whereas borrowers can get approved for a conforming loan with as little as a 3.5% down payment.

Currently, the FHFA limits for a conventional conforming loan are $510,400 in most counties and $765,000 in high-cost areas. Non-continental states and territories like Hawaii, Alaska, and Guam can have even higher limits.

How does a jumbo loan work?

A jumbo loan works very similarly to a conventional loan. The main difference is that the requirements to get approved for one are more strict.

But once the borrower is approved for the loan, it works much like any other home loan. The buyer will sign a mortgage contract with their lender, which gives the lender power of sale over the house — If the borrower defaults on their loan (doesn’t pay it back), the lender can sell the house to recoup the value of the loan.

In a conventional loan, the federal government offers assistance to the lender when a borrower defaults, but that’s not the case for jumbo loans — hence the increased risk.

Over the course of the lifetime of the loan, the borrower will need to pay back two things: the principal and the interest. The principal is the cost of the house, and the interest is a fee the bank charges as a percentage of the loan amount.

Jumbo loans are available as both fixed-rate and adjustable-rate mortgages. In the former, the interest rate stays the same throughout the lifetime of the loan. In the latter, the interest rate can change during the course of the loan.

What is the difference between a jumbo loan and a conventional loan?

Jumbo loans and conventional loans are overwhelmingly similar. Both loans require a mortgage contract, and home loan requirements have become stricter across the board since the 2008 recession.

But conventional loans stay within the conforming loan limits set by the FHFA, and they are guaranteed by Fannie Mae and Freddie Mac. If the borrower defaults, the federal government will come to the lender’s rescue and pay the principal and interest on the loan.

Jumbo loans, on the other hand, do not stay within those limits. Consequently, they aren’t guaranteed by the federal government, which makes them riskier for lenders. To compensate, lenders impose stricter approval requirements.

How do you qualify for a jumbo loan?

To get approved for a jumbo loan, borrowers need to prove that they have strong financials. Typically this means:

  • A credit score over 700 or 720
  • A debt-to-income (DTI) ratio lower than 43%
  • A significant down payment, usually at least 20%
  • Proof of income, such as pay stubs and two years of tax returns
  • Proof of liquid assets (cash) equal to 3-24 months of mortgage payments
  • Documentation for all other outstanding loans

Overall, it’s harder to get approved for a jumbo loan than it is to get approved for a conventional loan. Borrowers can get approved for a conventional conforming FHA loan with a FICO credit score as low as 500, for example, while the minimum for a jumbo loan is typically at least 200 points higher.

What are jumbo loan rates?

In the past, the average interest rates for jumbo loans were significantly higher than the rates for a conventional mortgage — over half a percent higher. However, over the past few years, mortgage rates have fallen and are now in line with conventional loan rates.

In 2017, the average interest rate for a 30-year fixed-rate jumbo loan was 4.15%, which was exactly the same rate as a traditional 30-year fixed-rate mortgage loan. On March 11, 2020, the interest rate for a 30-year fixed-rate jumbo loan was 3.250% and the interest rate for a traditional fixed-rate mortgage of the length was 3.436%.

What are jumbo loan limits?

Unlike conventional loans, there is no hard limit for jumbo loans. Instead, individual lenders set their own limits. In some cases, lenders will approve jumbo loans for up to $5M, but this varies from lender to lender.

What is the down payment on a jumbo loan?

Just like jumbo loan limits, there is no standard minimum down payment for a jumbo loan — Lenders are free to set whatever minimums they choose. Many lenders require a minimum down payment of at least 20% for a jumbo loan, but others will accept just 10% down.

Keep in mind that interest rates and down payments are generally negatively correlated: The lower your down payment, the higher your interest rate, and vice versa.

Plus, some lenders may require that you take out private mortgage insurance (PMI) if you don’t put enough down. PMI can take on some of the functions of a Fannie Mae and Freddie Mac guarantee — If you default on the loan, the insurance company will pay the lender to make up any unpaid principal and interest.

Who should take out a jumbo loan?

Jumbo loans are necessary for anyone who wants to mortgage a house in an amount that exceeds FHFA conforming loan limits. As of 2020, anyone mortgaging a home for more than $510,400 ($765,000 in high-cost areas) will need to take out a jumbo loan.

Jumbo loans have very strict approval criteria, so not everyone who wants to take out such a large mortgage loan will be able to. Approval for a jumbo loan generally requires a high FICO credit score, a low debt-to-income (DTI) ratio, high income, and proof of significant cash assets.

Since jumbo loans typically mean higher than average monthly loan payments, it’s important that you make sure you can afford the house you’re getting a mortgage for before you get in too deep.

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