For the most part, a jumbo loan is the same thing as a traditional loan. As the name implies, it is a larger loan than is traditionally given out. Across the country, Fannie Mae and Freddie Mac buy up the majority of residential and commercial loans issued. When the loan is too large for them to buy up, the mortgage brokers list it as a jumbo loan. As loans increase in size, the risk that is associated with them increases. Although Fannie Mae and Freddie Mac normally try to buy out loans to free up capital in the market, the added risk makes it impossible with this specific class of loans.
Setting the Limits
Fannie Mae and Freddie Mac operate as government-backed mortgage brokers. As the main purchasers of mortgage loans on the market, they set the limit for how high mortgages are before they are listed as jumbo. Since a $50,000 loan and a $5 million loan carry a different set of risks, the terms offered are different. In 2010, any loan that was over $417,000 was listed as a jumbo loan officially. In certain parts of the country, the higher price of land and cost of living push the limit up to $625,500. The specific areas the higher limit affected were the Virgin Islands, Hawaii and Alaska. A loan that is higher than these limits carries a much higher interest rate and requires a larger down payment. When the economy fluctuates, the limits for jumbo loans will change as well.
Higher Interest Rates and Higher Costs
Jumbo loans tend to have a higher default rate than traditional loans. To help mortgage companies leverage the risk, the jumbo loan must carry a higher interest rate. In recent years, lenders have also chosen to develop more stringent policies to protect their business from added risk. These stricter lending guidelines make it more difficult to get a jumbo loan, but also serve to drive down the interest rate.
Another way lenders try to protect their institution from risk is by raising the down payment requirement. For smaller loans, borrowers with good credit often only pay 5 percent of the loan amount or less as a down payment. With jumbo loans, the borrower pays at least a 20 percent down payment to secure the loan. Generally, a lender will also look for borrowers who have consistent, high incomes as well as at least a 720 on their credit score.
Why is There More Risk?
Jumbo loans are not just risky because of the money amount loaned out. These high-dollar loans carry other risks as well. Most jumbo loans end up buying property like luxury homes that are out of the price range of a normal consumer. If the loan is defaulted on, it can take months and years longer to sell than cheaper properties to sell. As the bank waits for the foreclosed on house to sell, the property value gradually drops as the years go by.
If a borrower runs into economic troubles and needs to refinance, the process is much more difficult with jumbo loans. Logically, it costs more to close the loan because of its high-dollar value. Borrowers are unable to refinance their loan and simultaneously unable to afford the one they have. Over the course of a few months, the borrower may start to fall behind on mortgage payments. If this happens, the lender is still stuck with trying to sell a foreclosed on house.
The higher value of the loan is not just a risk to the lender; the borrower stands to lose as well. When home prices fluctuate with the market, a luxury home owner will suffer a higher-dollar value loss when the economy takes a tumble for the worst. On the bright side, if the economy improves, the owner of the residential or commercial property can potentially make money off of their investment.