With house prices
cooling, it may be time to upgrade to that dream home which suddenly
appears within reach in this buyer's market. But with more property
comes more mortgage – as well as more options and more pitfalls. The
difference between a "conforming" and a "jumbo" loan could directly
affect your monthly mortgage payment. To shed light on how loans are
priced and sold, we turn to Barry Habib, an expert in the mortgage-backed securities market and CEO of Mortgage Market Guide.
Hot Potato
Mortgages, says Habib, are a lot like hot potatoes: no single
lender wants to hold on to one for very long. Lenders – much like
homeowners – want to make a profit on the loan as quickly as possible.
The aim is to leverage that profit in order to lend out more money to
borrowers and start the cycle again. Understanding this cycle is the
key to understanding how mortgages are funded, valued, and priced.
Let's take a closer look at this cycle illustrated below.
Step One: The cycle begins when a consumer secures
a loan funded by a mortgage lender. The consumer is given a competitive
interest rate based on a number of factors, including market
conditions, the price of mortgage-backed securities, and the consumer's
credit rating.
Step Two: Two of the biggest buyers of "conforming"
loans – more on what that means in a second – are Fannie Mae and
Freddie Mac. The lender takes its profit from the sale and then uses
that money to make another loan, continuing the cycle. Fannie and
Freddie, government-sponsored enterprises, pay a fee to the lender or
other servicing company to collect the mortgage payments.
Each year Fannie and Freddie set a maximum loan amount they are
willing to buy. Currently the conforming limit is $417,000 for most of
the U.S. (but just to make matters more confusing, this limit may be
changed temporarily this year in order to stimulate the economy.) Any
loan exceeding this limit, even by one dollar, is considered a
non-conforming or "jumbo" mortgage.
Step Three: The millions of loans purchased by
Fannie and Freddie are bundled into investment instruments and sold to
Wall Street investors. The Wall Street players securitize these bundles
into mortgage-backed securities and then sell those securities to
institutional and individual investors – including people like you and
me who buy them in the form of money market funds, mutual funds, and
pension funds. For every bundle sold and securitized there is a fee,
which is absorbed by Fannie and Freddie and spread across each loan in
the bundle. The more loans in a bundle the less the fee is felt by each
loan.
Step Four: Investment fund managers and consumers
buy and sell these securities based on their potential profits and
losses, setting the market demand and the interest rates for the next
home buyers who enter the cycle as well.
Now how about loans that aren't conforming?
Jumbo loans do not experience exactly the same cycle as
conforming loans. These larger loans must be purchased by private
investors, who don't buy in the same volume as Fannie or Freddie, so
their bundles contain fewer loans overall. When they bring these
bundles to Wall Street, they are hit with a fee just like Fannie and
Freddie, but the fee must be spread among fewer loans.
Historically, jumbo loans are one-quarter to one-half a percentage
point higher than the going rate for conforming loans. With the credit
crunch and post-subprime mortgage market, however, it has become much
more difficult to find an investor for jumbo loans. Therefore, the cost
of these loans has recently increased one percentage point or more for
conventional 30-year fixed rate mortgages.
What does this mean? Well, let's say you wanted to borrow $300,000
for a 30-year fixed–rate mortgage, you could pay 5.75% in today's
market. Not bad, right? That's one of the lowest 30-year rates since
2005. However, increase the loan amount to $500,000 to $600,000 and
your rate for the same 30-year fixed-rate mortgage could easily exceed
7.00% – and it doesn't matter if you have great credit or not because,
with this type of loan, great credit is expected of you.
The first key to success in today's real estate market then is
knowledge. While it's important that you understand at least the basics
of this process, you must have a true mortgage specialist on your side
to help you make the right decisions. This person should also have
access to many suppliers of money. This may allow you to obtain a lower
rate.
The second key to success is knowing and exploring all of your
options. What about a piggyback loan: a HELOC, or closed-end second
mortgage in conjunction with a conforming loan amount of $417,000? With
short-term rates on the decline, you may be better off choosing to take
a second mortgage with a higher rate than taking on a jumbo loan. Maybe
a longer-term fixed-period ARM is right for you. These may offer you a
lower – or at least a similar – rate to a jumbo loan. Ask your lender
for a side-by-side comparison of loan options that show your total
costs throughout the time you expect to have the loan in place.
Remember, what's right for others may not be right for you and vice
versa, so anyone who offers cookie-cutter advice is not looking out for
your best interest and is someone you shouldn't be working with. A
professional loan officer should ask you some of the following
questions before offering you anything. Without exploring this
information with you, they cannot truly help you:
- Do you have the ability to document your income?
- Do you have the ability to verify consistent liquid assets? In other words, can you document checking, savings, investment accounts, etc. for the most recent two-month period?
- What is your FICO score?
- (If you're refinancing) What is the value of your home?
Remember, home values have fallen in many areas recently, so the price
you paid may not be what your home will appraise for now.
- (If you're purchasing) What is the sales contract price?
- How long do you intend to have the mortgage in place?
The third key to upgrading to that house you always wanted is
action. Don't wait until the market changes directions again. Home
prices are down across the country and rates are near historic lows.
Find out if there is any way to use the market downturn as a stepping
stone to the house of your dreams. Pay attention to new legislation
that could increase conforming loan limits. But most importantly,
contact a professional today for specific advice as to your particular
scenario. The worst thing that could happen is you find out your
current mortgage is the best option you have.
UPDATE - Did you know that the conforming loan limits are being raised? Ask us what this might mean to you!