A jumbo loan is a mortgage designed to finance a property that is too expensive to qualify for conforming loans, which are government-secured mortgages that adhere to the Federal Housing Finance Agency (FHFA) financing limits (in most states up to $510,400). If you want to finance a home exceeding your local conforming loan limit, you will need to get a jumbo loan.
These loans are usually offered by banks and private lending institutions. Since the loans are not government-backed, the lender carries the risk if you don’t pay back your loan. Hence, these lenders look to mitigate the risk with more stringent qualifications, including a higher credit score, a larger down-payment and higher interest rates than conforming loans.
Jumbo loans help borrowers finance real estate in highly competitive markets. They are especially important for borrowers who want jumbo loans to purchase more expensive homes. If you want a luxury home and you’re unable to put down a large down payment, a jumbo loan may provide you with a viable option.
How Does a Jumbo Loan Work?
To understand how a jumbo loan works, it’s helpful to understand the role Fannie Mae and Freddie Mac play in the loan marketplace.
Fannie Mae and Freddie Mac are Government-Sponsored Enterprises (GSEs) that fund most of the home mortgages in the United States. These GSEs reduce the risk for lenders because they guarantee the loan. Consequently, lenders can issue more affordable loans knowing that if a borrower defaults on the loan, these GSEs will cover that loan.
With that in mind, a jumbo loan is a loan product for properties that are more expensive than the limits set forth by the Federal Housing Finance Agency (FHFA) to be eligible for Fannie Mae and Freddie Mac loan protection.
The FHFA limit for 2020 is $510,400 in most markets and up to $765,600 in designated high-priced markets.
Without the loan guarantee from Fannie Mae and Freddie Mac, the lender takes on more risk since they are not protected from losses if the borrower defaults on the loan. Understandably, lenders are very cautious when they are vetting an applicant’s ability to repay a jumbo loan. Typically, a borrower must have an excellent credit score to go along with a low debt-to-income ratio.
Jumbo loans can have either fixed or adjustable terms, with the average APR that is roughly the same as with conforming mortgages. Borrowers usually need to put down a minimum of 10% to 15% of the total purchase price for a down payment.
Requirements to Qualify For a Jumbo Loan
The requirements to qualify for a jumbo loan are similar to those for most loans; your income, reserves, credit score, debt-to-income (DTI) ratio, and employment status all factor into the qualification requirements.
With no government safety net, underwriters for jumbo loans are more stringent during the application process. Here are a few examples of the requirements you’re likely to find in the jumbo loan marketplace:
Higher Credit Score
Jumbo loans require an excellent credit score with some lenders wanting a credit score of 720 or higher. Most lenders will not accept a credit score lower than 660 for these loans. By contrast, borrowers often qualify for government-backed loans with credit scores as low as 600.
Higher Down Payment
While some lenders may approve a conventional jumbo loan with as little as 5% down, they will attach private mortgage insurance (PMI) to the loan for their protection for a down payment this low. However, most lenders require a down payment of at least 20%, which eliminates the need for PMI.
Lower Debt-to-Income Ratio
Debt-to-Income (DTI) ratio is the amount of debt you carry relative to your income. In other words, it represents how much of your gross income is dedicated to paying all of your debts each month.
Ideally, your DTI ratio should be lower than 36%. To put it in perspective, loans that are secured by the government may approve borrowers with DTI ratios of up to 50%.
More Cash Reserves
Most mortgage lenders like to see that a borrower has cash reserves, including savings and liquid assets, available in case of an emergency. For a conventional jumbo loan, you will usually need to have three to 24 months in available cash for housing expenses, compared to as low as one month in cash reserves for conforming loans.
To meet the reserves requirement, you don’t have to pull your money out of your accounts, but the funds should be liquid. Here are a few guidelines to remember:
- Money in your savings account qualifies as being liquid, which means it counts towards any necessary cash reserves.
- Gift and business funds are sometimes considered as eligible cash reserves if your financial profile is strong in other areas such as your debt-to-income ratio and down payment.
- Lenders may consider 70% of the balance of your retirement and investment accounts to be liquid.
In some instances, the lender may provide an exception to this reserves requirement if your DTI ratio is low and you plan on putting down a large down payment.
When Does a Jumbo Loan Make Sense
Jumbo loans may provide the only option for some home buyers to get a luxury home which costs considerably more than the average home in the area.
These loans are ideally suited for those who can afford the mortgage, provide a large down payment, possess excellent credit and can pass the rigorous vetting process.
Jumbo loans are appropriate for a segment of buyers who earn between $250,000 and $500,000 a year. This demographic group is often called HENRY, the acronym for “high earners, not rich yet.” In other words, the HENRY set has a lot of income coming in, but they have not yet accumulated millions of dollars in savings and other assets.
When To Avoid a Jumbo Loan
For many people, getting a jumbo loan is not a good idea, particularly if you will struggle to meet the requirements.
It’s also wise to be cautious if you think you may need to sell the home quickly at some point.
Take into account the activity level of your local real estate market. For instance, if your home is expensive but there’s little market movement in your area, you could find yourself on the hook financially for a home you no longer want.
Even in an active market, the application process can be rather slow, meaning it could be a while before a suitable applicant is approved.
The Bottom Line
If you want to buy a large property or a high-priced luxury home, a jumbo loan might be the best mortgage option for you. This is particularly true if you don’t want to add a piggyback loan to the original mortgage to finance the purchase.
Make sure you can afford the monthly mortgage payments before you sign your name on the loan documents. While the property may be your dream home, it’s not worth putting your financial future at risk.
