There are two basic classifications for a mortgage loan- conventional and government-backed.
Government-backed loans include the VA, FHA and USDA programs.
The VA loan is reserved for veterans and others who qualify to buy and finance a primary residence. USDA loans are also used to finance a primary residence but the property must be located in a specific area and there are certain income limits the borrowers must meet. The FHA loan, the last of the three, is used to finance a primary residence but there are no limits as to military service, location or income limits. Each of these three programs carries an inherent government-backed guarantee should the loan ever go into default. If the loan goes bad, the lender is compensated for part or all of the loss. There are also maximum loan amounts based upon the loan type or location.
Conventional loans do not have such a guarantee other than the lender’s experience approving mortgage applications. A lender that approves a conventional mortgage realizes there is no such compensation if the loan is foreclosed upon. Conventional loans also fall into two categories—conforming and non-conforming, commonly referred to as “jumbo” mortgages. Conventional conforming loans are those approved using underwriting guidelines established by Fannie Mae or Freddie Mac.
Buyers can finance real estate for a primary residence, second home or investment property and there are no geographical or income limitations and are by far the most common form of financing real estate. There are however loan limits for a conforming loan and today the loan limit is $417,000 in most parts of the country and as high as $625,500 in certain areas that are deemed “high cost.” When lenders approve loans using these guidelines, they are free to buy and sell these loans to one another, to investors or directly to Fannie Mae or Freddie Mac. Doing so frees up more funds to make still more loans. Here in San Diego County the maximum conforming loan limit is $580,750 and anything above that amount is considered a jumbo loan in 2016.
When lenders approve loans using these guidelines, they are free to buy and sell these loans to one another, to investors or directly to Fannie Mae or Freddie Mac. Doing so frees up more funds to make still more loans. Here in San Diego County the maximum conforming loan limit is $580,750 and anything above that amount is considered a jumbo loan in 2016.
The Jumbo Purchase Calculation
Loans that are above the local conforming loan limit are jumbo loans. For mortgages beyond the $580,750 maximum, a jumbo loan will be used. These loans do not have such a deep secondary market like Fannie and Freddie loans have, but there is a secondary market for most nonetheless. Approval guidelines for jumbo loans can vary between lender to lender but most follow some basic patterns.
Jumbo loans typically ask for a fully documented filed. This means borrowers must provide third party verification for all aspects in the loan application. As it relates to income for example, borrowers will be asked to provide their most recent pay check stubs covering a 30 day period. Lenders will then use this gross monthly income to qualify the borrowers. The two most recent W2 forms are also a standard requirement and will verify a two year employment history, again a common thread for a jumbo approval. If the borrowers are self-employed or receive additional income outside of a job and need that income to qualify, the borrowers then provide the two most recent federal income tax returns.
If the business is a sole proprietorship, the net income on Schedule C will be used, adding back any depreciation listed. If the business is a partnership, partnership returns will also be needed. The same for an LLC or corporation. In these examples, both personal and business tax returns will be required.
Jumbo loans also require that self-employed income must have at least a two year history and be consistent from year to year. When calculating self-employed income, jumbo lenders will average the net income over a two year period. There will most always be a variance in business income from year to year and this is not only normal it’s expected. Variances from 10-20% year-over-year are generally acceptable. Lenders provide a bit more scrutiny in year-over-year income when year two shows a significant reduction in income. For example, year 1 shows $100,000 in income while year 2 shows $90,000. In this example, the qualifying income is then $190,000 divided by 24 (months) or $7,916 per month. If year 2 income is say $50,000, the income is calculated at $6,250. Such a difference between the two years would cause the lender to decline the loan primarily due to declining income or otherwise provide documentation the drop in income was beyond the borrower’s control and the event that caused the decline has either passed or corrected.
A year-to-date profit and loss statement will also accompany the federal tax returns. Most jumbo loan programs don’t require this P&L to be completed by a CPA or otherwise audited, but some do. It’s completely up to the lender.
Assets are fairly straightforward. If the jumbo loan requires at least a 20% down payment the lender will look for at least that amount plus funds needed for closing costs. Some jumbo loans also require cash reserves to be available in a liquid or semi-liquid account. Cash reserves for a jumbo purchase loan are expressed as a number of months of mortgage payments including property taxes, insurance and mortgage insurance if the borrowers put down less than the 20% requirement.
These assets are validated by providing the most recent three months of bank and investment statements from the accounts that will be tapped into for the purchase transaction. There are times when the assets being used for the transaction have more than one name on the account. In the instance of a marriage and both spouses are on the statement as well as the loan applications there are no issues. However, if there is an additional name on the statement other than the borrower, the lender may only use half the stated assets, assuming there is an even split between both parties. Additionally, the jumbo lender may ask the individual not on the loan application but on the statement to provide a written statement saying the borrower has permission to use the funds as needed.
If the funds are being held by an entity other than the borrower such as a trust, the jumbo lender will then verify the borrower has the legal authority to withdraw an amount of funds at will. In the instance of a trust, the jumbo lender will review the trust documents to verify this authority.
Business assets may also be used but only under certain specific conditions. First, the borrowers must validate they have the authority to withdraw and otherwise control the funds. Second, a document written by the company’s accountant the withdrawal of a specific amount of funds would not harm the short or long term operation of the business. Businesses do need cash flow to survive and the withdrawal of funds such that the business could not operate, the jumbo lender would not permit the business funds in this instance to be used.
Many times, jumbo lenders will require a slightly higher credit score when compared to a conventional mortgage. For jumbo purchase or refinance loans with a loan balance of 80% or lower than the current value, a 720 credit score requirement is common. When borrowers put much more down when qualifying for a jumbo purchase loan, say 40% or more, the lender can become more lenient when reviewing the application as there is less risk involved due to the greater initial equity provided by the borrowers.
Jumbo lenders will request a credit score from each of the three credit repositories, Equifax, Experian and TransUnion. These three numbers will most always be similar to one another and the lender will throw out the highest and lowest score, using the middle number. When there is more than one borrower applying for a jumbo refinance or purchase loan, the lender will use the lowest middle score of all borrowers.
There are occasions when the borrowers on the application have a wide disparity in qualifying credit scores. Sometimes the lowest middle credit score is below what the jumbo lender requires and the loan could be declined. However, if the borrower with the higher credit score can qualify on one income while also being able to qualify based upon the debt among all who will hold title, the loan can still be approved, leaving the borrower with the lower credit scores off the loan application entirely.
Mortgage rates for jumbo loans, either for a purchase or a refinance, will typically be slightly higher than rates reserved for conforming loans, although that isn’t always the case. For a 30 year fixed rate conforming loan the rate might be 3.75% but for a jumbo loan the rate may be 4.00% under the same scenario. Jumbo interest rates for a purchase or a refinance can also vary based upon the amount of down payment and the qualifying credit score. For example, someone with a 750 credit score and 30% down can have a slightly better interest rate than someone with a 720 score and 25% down.
Interest rates will also be higher for jumbo loans when the property is not the borrower’s primary residence. The home could be a beach home, mountain retreat or a rental property. Rates for a vacation home will be a bit higher than for a primary residence and higher still for an investment property.
Rates can also be adjusted based upon paying discount points to lower the rate. All jumbo lenders can offer a combination of rates and points. A discount point is expressed as a percentage of the amount borrowed and is used to reduce the rate on the loan. Discount points are considered a form of prepaid interest and may be a tax deductible item just as mortgage interest for those who qualify and itemize. Lenders have no preference regarding points and the decision has little effect on the loan other than the monthly payment. Lenders do not care whether or not a borrower pays points as the net to the lender is essentially the same.
So far we’ve discussed jumbo loan programs with at least a 20% down payment requirement. As their conforming cousin, mortgage loans greater than 80% of the current value of the property can require a third party, private mortgage insurance, or PMI. PMI is an insurance policy that covers the difference between the borrower’s down payment and the minimum 20% down payment. If the borrowers put down 10% and the loan requires a 20% down payment, PMI can be purchased by the borrowers to cover the remaining 10%.
However, there are other options that do not require any private mortgage insurance at all. For example, one of our jumbo loans used to purchase or refinance a property needs just a 10% down payment and no PMI. This is accomplished with a combination of a first and second mortgage. For instance, a $1MM home with 10% down could have a first mortgage of $750,000 and a second mortgage of $150,000. The property is then secured with two loans totaling $900,000 with the borrowers putting down 10%, or $100,000. The minimum credit score for this loan program is 730 and requires six months of cash reserves. The maximum property value for this jumbo loan type is $1.6MM. Not many jumbo lenders offer this program, much less be aware of it.
Another popular program for those wanting to put less than 20% down while financing a more expensive property up to a sales price of $2 million requires a 15% down payment and a higher credit score at 740. Cash reserves for this loan total 18 months, not six like the previous loan, and is also a combination of a first and second mortgage. This combination also eliminates the need for costly PMI.
There are distinct advantages when taking out a first and second mortgage. Second mortgages will always carry a slightly higher interest rate compared to a rate reserved for a mortgage in first position yet this higher rate still yields a lower monthly payment compared to a monthly PMI policy. As well, the second mortgage as well as the first can be paid off at any time without penalty. For example, borrowers want to buy a $1.5MM home with as little down as possible as they are in the process of selling their existing home and want to use the proceeds from that sale to buy the new home. If the home has not yet sold, the borrowers can still put down 10% and use a first and second mortgage combination and when the existing home sells the proceeds can be used to pay off the second mortgage entirely, eliminating the loan and the accompanying mortgage payment and leaving just the first mortgage with the more competitive interest rate and lower payment.
Both of these options when financing a jumbo purchase offer both fixed rate and adjustable rate loans both fully amortizing and offer an interest only option. The 3/1 and 5/1 hybrid option is also an excellent choice for borrowers who anticipate not owning the property or otherwise keeping the mortgage for a short, 3-5 year period. These loans offer rates that are slightly lower than a fixed rate option yet provide the stability of a fixed rate loan over the initial period at which point the mortgage transforms into a mortgage that can adjust over time.
Using a first and a second mortgage to buy and finance a jumbo purchase it also has a strategic advantage. Buyers don’t have to tie up as much of their funds when putting down say 10%. Buyers have the ability to sell their existing home at a later date and then use the proceeds from the sale to pay off the second mortgage entirely and even pay down the first mortgage.
Let’s say there is a couple who is listing a home for sale at $900,000 and wants to buy a home for $1.5 million. If they put 20% down in that transaction those funds will be in the property and no longer liquid. They make an offer on the new home and close on the transaction while waiting for their existing home to sell. In this scenario, there is a first mortgage of $1.2 million and a second representing 10% of the sales price at $150,000. The couple finally gets an offer on their previous home and uses the proceeds from that sale to pay off the existing $150,000 second lien. They didn’t have to put 20% down to complete the new sale and preserved their liquid funds in the process.
Fixed or Adjustable?
All jumbo mortgage loans have an associated mortgage rate and again that rate can vary based upon several factors but there are different loan types jumbo buyers can used such as a fixed rate or a hybrid. But beyond deciding whether or not to pay discount points to get a lower rate, which is better, a fixed or a hybrid?
A fixed rate mortgage is just that. Hard-wired into the note is an interest rate that can never change throughout the life of the loan. A fixed rate is easier to plan for because the borrower knows what the rate will be 10 years from now and fits in nicely with financial plans. Shorter term fixed rates will typically be lower than a longer term fixed rate loan. A 30 year fixed rate will be higher than a 15 year yet the payment on a 30 year will be lower. The advantage of a 15 year is the lower interest paid to the lender over the life of the loan. Which is better, a 30 or a 15? While a 30-year mortgage is the most common, especially for a non-jumbo loan, the amount of interest is almost triple on a 30 year compared to a 10. Many suggest taking the shortest term available that’s still comfortable paying each month. And besides, one can always refinance to a shorter term if a shorter term jumbo loan is currently available in the market.
A hybrid is a loan that can adjust at some point in the future after an initial fixed rate period. Hybrids are market “3/1, 5/1, 7/1…” and so on with the initial digit representing how long the rate is fixed and the second digit, the “1” represents a one-year adjustable when the rate may adjust once per year. The benefit with a hybrid loan is the lower rate when compared to a fixed and is a popular choice for those who do not intend to own the property for an extended period of time.
At the end of the initial fixed term the loan turns into an adjustable rate based upon an index and a margin. A common index might be LIBOR and a typical margin 2.25%. If an arm is about to adjust the lender takes the current LIBOR index then adds the margin to obtain the rate for the following year. This is repeated annually for the life of the loan. The drawback is not knowing where indexes will be in the future and not knowing where rates will be four, five or six years from now does present an element of risk not associated with a fixed rate loan. Generally speaking, a hybrid is a better choice when owning for a shorter term is in the mix while a fixed rate is for the longer haul.
The Jumbo Landscape
The secondary market for jumbo loans is much smaller compared to conventional and government fare. This means there can be “boutique” loans designed for a specific class of borrower. A jumbo lender who uses its own lending guidelines to cater a particular market can be a lucrative proposition for them but on the other side, such loans are more difficult to find for the typical jumbo borrower. In addition, such lenders have the ability to make lending exceptions on a case-by-case basis that can more easily accommodate a jumbo borrower’s current financial situation.
The bottom line is there are more jumbo choices in today’s environment than most consumers are even aware of. That means there are more choices but if no one knows about them the consumer doesn’t benefit. There is a lot more out there than just the standard 20% down jumbo loan. There are options that might better fit your personal requirements.
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