Mark Rosen and his wife had just found the perfect house in an up-and-coming Chicago neighborhood when their mortgage broker uttered a word they really didn’t want to hear: jumbo.
To buy the three-bedroom house, Rosen and his wife, Dina Shiner, needed to borrow about $317,000, an amount considered too high for the buyers to qualify for a “plain vanilla” mortgage. So, like thousands of other higher-income couples, the couple was thrust into the bewildering world of the jumbo mortgage market, so called because the loans are bigger than average. In fact, any mortgage in excess of $275,000 — raised from $252,700 in 2000 — is considered a jumbo.
Such loans, which accounted for about 21 percent of the $1.1 trillion in mortgages issued last year, carry higher interest rates than ordinary mortgage loans and end up costing buyers thousands of dollars in extra interest payments. But as Rosen and his wife found, there are sometimes ways to work around the problem and avoid a jumbo. Instead of one big mortgage, they plan to take out two smaller loans that they expect will save them some $35,000 in interest over the life of their loans.
The cutoff “seemed to be so arbitrary,” says Rosen, a 34-year-old software developer. “You’re never going to be able to explain to me why a $300,000 loan is more expensive” than a similar — but smaller — one, he says.
Just why do jumbos cost so much more? For years, the conventional wisdom has been that lenders had to charge more for jumbos because the loans aren’t backed by Fannie Mae and Freddie Mac, the giant government-sponsored loan purchasers. The two companies exist to buy eligible mortgages from banks and other lenders, freeing up lenders to make more loans, and in the process, they’re supposed to lower interest rates for the home buyers who qualify.
Fannie and Freddie, which are mandated to help low- and moderate-income homeowners, are prohibited from buying loans over a certain amount. That limit, which sets the cutoff between ordinary loans and jumbos, is adjusted every year using data from the Federal Housing Finance Board, an independent housing-related agency.
Lately, though, many of the old assumptions about the mortgage market have been called into question. A controversial study published by the Federal Reserve in October suggested that Fannie and Freddie don’t necessarily affect the interest rates paid by home buyers.
At the same time, many mortgage experts believe that factors unrelated to Fannie and Freddie contribute to jumbo loans’ higher prices.
Despite the Fed study, though, the vast majority of mortgage experts still think Fannie and Freddie play some role in prices, although they don’t know how much. For one thing, loans that fit Fannie’s and Freddie’s guidelines are easier to package and sell as securities to investors, and that allows lenders to charge lower rates for those loans.
Mortgages that don’t fit the companies’ guidelines, like jumbos, are sometimes harder to sell, especially in times of economic stress. At the same time, Fannie and Freddie are able to borrow more cheaply than other private-sector companies because of their ties to the federal government, and at least some of that savings is passed on to borrowers who qualify for Fannie- or Freddie-backed loans in the form of lower rates.
Many mortgage experts think other forces are at work, too. Jumbo loans are typically used to buy large, expensive houses, which are harder to sell during a recession, making the loans riskier for lenders.
And an $800,000 loan that goes sour also can whack a lender or investor a lot harder than a $150,000 bad loan. “The higher the dollar amount, the higher the risk,” says Keith Gumbinger, a mortgage analyst at HSH Associates, a Butler, N.J., financial publisher.
Finally, there’s the problem of “prepayment” risk. Jumbo borrowers, who tend to be more affluent and more financially savvy than other home buyers, are more likely to pay back loans quickly in order to save money on interest.
That, of course, is the last thing lenders and secondary-market investors want, because it cuts their profits. So they tend to charge more.
Unfortunately for home buyers, there’s not much that can be done to change the factors that make jumbo rates higher. However, there are ways to mitigate the pain.
Borrowers might make a bigger down payment in order to drive the loan amount below the jumbo cutoff.
But making a bigger down payment isn’t always an option. Rosen and Shiner, for instance, felt that they could put down only about 10 percent of their home’s $352,700 purchase price.
In such cases, borrowers might want to consider an adjustable-rate mortgage. Such mortgages, which carry a fixed interest rate for a set period of time and then “adjust” up or down every year based on the performance of Treasury notes or various market indexes, aren’t always subject to the same forces that guide pricing for other loans, because lenders tend to keep them in their own portfolios rather than selling them to the secondary market.
The interest rate on a five-year ARM, for example, is sometimes as much as half a percentage point lower than the rate on a fixed-rate jumbo, and that rate is often available for loans as big as $650,000.
However, many people don’t like them because of the uncertainty that arises after the initial fixed-rate period ends. In particular, ARMs aren’t always a good bet for people who intend to stay in their houses for a long time.
For those kinds of borrowers, there’s the “piggy-back” option that Rosen and Shiner are getting.
Under the advice of their broker, Perl Mortgage Inc. of Chicago, they plan to take out two loans: one for $275,000 at approximately 7.375 percent, and a second loan for $42,430, at a higher fixed interest rate of about 8.75 percent.
By combining two loans, Rosen and Shiner will have a monthly payment of about $2,230 a month, which was less than the $2,330 or so it would have cost them each month had they taken out a 30-year jumbo loan. In addition, the two loans were structured so Rosen and Shiner didn’t have to pay mortgage insurance, which is typically required when the down payment is less than 20 percent.
Their monthly payments should drop even more after they use the proceeds from a condominium they are selling to pay down much of the second loan.
When that loan is finished off, they will be left with a single loan at the lender’s best rate.
The combination approach won’t work for a lot of people, though. Often, second liens carry such a high interest rate that they become prohibitively expensive. For people who need to borrow lots of money — say, $800,000 — the higher interest rate on the second loan would dwarf the savings achieved from the first loan.
Indeed, some people who need to take out really big loans may have to just accept the fact they’re going to pay for the privilege.
“Some people,” says Gumbinger, the HSH analyst, “are still going to go away unhappy sometimes.”
