A jumbo loan is a mortgage used to purchase expensive properties that exceed the loan limits of conventional loans. As the name suggests, these loans are large, but the size isn’t the only factor that makes these loans different from other types of loans.
Real estate professionals must understand loan types which include jumbo loans. I’ve been helping students with their real estate exams, and I’ve noticed that most students can’t properly define real estate terms. But don’t worry, I’m here to help.
In this post, I’ll define jumbo loans with the help of examples. After reading this post, you’ll be able to learn the definition of a jumbo loan and understand how it works. You’ll also be able to differentiate it from other types of loans. So, let’s read on without further ado.
What Is a Jumbo Loan?
A jumbo loan is a mortgage that exceeds the limits Fannie Mae and Freddie Mac set. This type of loan is not guaranteed, scrutinized, or purchased by Fannie Mae or Freddie Mac as it exceeds the limits set by these organizations. Since it exceeds the borrowing limits of these organizations, it is also known as a non-conforming loan.
A jumbo loan allows borrowers to use a huge loan to purchase expensive properties. It has stricter credit requirements than conventional loans. It requires a good credit score and a low debt-to-income ratio to qualify.
The loan can be used to purchase homes that are too costly to purchase using conventional loans—for instance, vacation homes, investment properties, and more.
Since Fannie Mae and Freddie Mac don’t guarantee these loans, lenders consider them riskier. Thus, lenders offer higher interest rates and provide jumbo loans only to borrowers with stellar credit scores.
How Does a Jumbo Loan Work?
To understand how jumbo loans work, you must first understand what conforming loans are. A conforming loan is a loan that meets the requirements set by the Federal Housing Finance Agency (FHFA). FHFA also supervises Fannie Mae and Freddie Mac.
Conforming loans meet the funding criteria of these two government-backed organizations too. On the other hand, jumbo loans don’t meet Fanie Mae’s and Freddie Mac’s funding criteria and the borrowing limits set by the FHFA.
FHFA sets the borrowing limits annually and authorizes Fannie and Freddie to purchase loans and mortgages from various financial institutions. However, these organizations can only purchase those loans that meet the criteria set by the FHFA.
The ability to sell a loan to Fannie and Freddie is a type of safety for mortgage lenders. Jumbo loans are non-conforming loans, but they still need to follow the guidelines of the Consumer Financial Protection Bureau.
Jumbo Loan Requirements
Jumbo loans are risky; thus, they have stricter requirements than conventional or conforming loans. The borrower must fulfill many requirements to get approval for a jumbo loan. The following are the factors that the borrower must consider before applying for a jumbo loan:
Large Income/ Low DTI
Lenders look for borrowers with huge incomes to offer a jumbo loan. They calculate the debt-to-income ratio, the percentage of monthly income spent on paying debts. A lower debt-to-income ratio means that the borrower has a high income which is more than enough to repay their monthly debts.
For example, if the borrower spends $3,000 per month and earns $5,000, their DTI is 3000 divided by 5000, which equals 60%. A 60% DTI is high, and the borrower must score below 43% to qualify for a jumbo loan.
High Credit Score
Most jumbo mortgage lenders require a FICO credit score of at least 700. The average credit score to qualify for a jumbo loan is 740, but some people also have qualified for this loan with a 680 score. The higher the credit score, the lower the interest rates on a jumbo loan. The credit score requirement for a jumbo loan is higher than that of a conventional loan.
Huge Cash Reserves
To qualify for a jumbo loan, the borrower must have additional assets. Lenders look for borrowers’ capital and assets in case of a missed payment or a delinquent mortgage. If there is a missed payment on the borrower’s behalf, the lender can look towards these assets and capital to cover their losses. Borrowers with assets covering at least one year of loan payments are considered suitable applicants.
Large Down Payment
Jumbo loans have higher upfront costs, which include a down payment. With conventional mortgages, borrowers can make down payments as low as 5%. However, lenders require a downpayment of 20% or more for a jumbo loan. Some lenders might accept a 10% upfront, but most will ask for 20% or 30% to reduce risk. Jumbo loans have much higher closing costs.
Jumbo Loan vs. Conforming Loan
There are several noticeable differences between a jumbo loan and a conforming loan. The following are the key features of a jumbo loan that distinguish it from conventional or non-conforming loans:
Jumbo Loan Limits
If someone wants to borrow more than the loan limits in their area, a jumbo loan will help. The loan limits set the conventional loan apart from a jumbo loan. For instance, the conforming loan limit is $726,200 for single-family homes.
On the other hand, the loan limit for more expensive areas such as Hawaii and Alaska is $1,089,300. The jumbo loan limits vary according to the geographic location and are higher than the conforming loan limits.
Jumbo Loan Rates
Jumbo loan rates are higher than conventional loans. The lender takes a risk by approving a jumbo loan; to lower that risk, they offer high-interest rates. High-interest rates mean high mortgage payments. On the other hand, conventional loans are not risky for lenders, and their rates are usually lower than the jumbo loan rates.
Conventional loans are secured and guaranteed by Fannie Mae and Freddie Mac, whereas Jumbo Loans aren’t. This also explains why lenders consider Jumbo loans riskier than conventional loans.
Unlike conventional loans, borrowers can purchase expensive and luxurious properties with Jumbo loans. Also, there is no restriction on the property type with a Jumbo loan. A jumbo mortgage allows borrowers to purchase a primary residence, second homes, vacation homes, and investment properties.
Pros of a Jumbo Loan
- Allows you to borrow more than the conventional loans
- Opportunity to purchase a larger property
- Great investment opportunities
- Flexibility to buy different types of properties
- No private mortgage insurance (PMI)
Cons of a Jumbo Loan
- Higher credit score requirements
- Large annual income
- Additional assets to cover 6 to 12 months of repayments
- Higher interest rates
Jumbo Loan Examples
John wants a property worth $900,000 to purchase a vacation home in Alaska. The following is a breakdown of John’s financial profile and the loan amount:
- Loan amount: $900,000
- Down payment: 20% ($180,0000
- Term: 30 years
- FICO score: 740
- Borrower’s age: 58
- Monthly income: $30,000
- Monthly debts: $10,000
- Debt-to-income ratio: 33.33%
After evaluating John’s creditworthiness, the bank approves the loan and offers a jumbo loan.
Frequently Asked Questions
What Are the Jumbo Loan Requirements?
Jumbo loan requirements are more strict than conventional loans. These are as follows:
• A high credit score (680 to 740 or more)
• Lower debt-to-income ratio (less than 43% but acceptable up to 50%)
• Higher down payment (20% or more)
• Additional assets
What Are Considered Jumbo Loans?
A loan is considered a jumbo loan if the amount exceeds the borrowing limits set by Fannie Mae and Freddie Mac. These organizations set ‘conforming loan limits’ for conventional loans. Jumbo mortgages allow qualified applicants to purchase very expensive properties that can’t be purchased with conventional loans.
Who Should Get a Jumbo Loan?
People living in areas with high property values can consider jumbo loans. These loans are mostly used by home buyers who want to purchase high-end and luxury properties which they can’t purchase with conventional loans. However, a jumbo loan also causes an increase in financial limits; thus, it is better to consider all the factors and get a jumbo loan. To sum up, people earning around $250,000 to $500,000 a year can afford jumbo loans.
What Are Jumbo Loan Limits?
Currently, the loan limits for conventional loans are $726,200 for single-unit properties, as set by the FHFA. In more expensive areas such as Hawaii, U.S. Virgin Islands, and Alaska, the conforming loan limit is $1,089,300. The jumbo loan limits are higher than these limits, which allows the borrowers to purchase more expensive properties.
What to Know for the Real Estate Exam
A jumbo loan is a loan that has a higher borrowing limit than conventional loans. These loans have stricter credit requirements and higher upfront costs. Unlike conventional loans, the funding criteria of these loans are not according to the guidelines set by Fannie Mae and Freddie Mac.
Moreover, the borrowing limits of jumbo loans aren’t set by the FHFA. Because these loans aren’t guaranteed or secured by the GSEs, they are considered riskier for the lenders.
I hope now you’ve learned how to define a jumbo loan. To grasp other real estate concepts well, go through these easy-to-learn real estate definitions.