There’s always a misconception when people hear “zero money investment” in the real estate realm. I’ve met people who seem to have the impression that they should simply make as little of a down payment as possible. As I’ve reiterated many times on this website, this is simply not the case.
One big reason why I advocate against paying a very low down payment is that your interest rates can get very high.
But Marcel, aren’t interest rates based solely on your credit?
Well, that would be great news for people who have been meticulously maintaining great credit. Unfortunately, it is a bit more complicated than that. The location of the property and size of the loan all come into play here.
Today, I’ll talk about why the size of a loan affects your interest rates. In particular, I’ll illustrate my points by introducing you to the Jumbo Mortgage.
What is a Jumbo Mortgage?
A Jumbo mortgage is a usually a very large mortgage that exceeds the conforming loan amount stipulated by Fannie Mae and Freddie Mac, two Government Sponsored Enterprises (GSEs).
This conforming loan amount relates to the maximum value of an individual loan that the GSEs will purchase from a lender. Basically, what happens is that GSEs will buy loans off mortgage lenders so that they have enough liquidity to hand out more loans.
The conforming loan amount set by GSE is $424,100 in 2017. However, this amount fluctuates from year to year.
So what’s it go to do with me?
The big deal is this: say you’re purchasing a huge property. You put almost no money down, and have to borrow a large amount – say, $700,000.
Congratulations my friend, you’re going to be paying out your nose in interest for that $700,000. Imagine doing that for a few years. Cash. Flow. Killer!
Why would your interest rates be so high?
Firstly, your mortgage lender knows that ol Fannie Mae and Freddie Mac won’t be buying out the full $700,000. This means that the lender is left holding the risky bag of your mortgage. With the added risk, the lender has no choice but to be compensated through a higher interest rate. And you’re the one paying the higher interest rate.
Secondly, large loan amounts mean higher priced properties. Higher priced properties generally stay on the market for longer before they are sold. In other words, they’re harder to sell.
Guess what? In the event that a homeowner defaults on a loan, it’s going to be mega hard to sell the property and recoup the cash. I should also mention that a higher loan amount = higher interest rate = higher chance that you’ll run into financial difficulties.
These things again increase risk for the lender, resulting in higher interest rates.
What other issues are there?
Jumbo loans are usually harder to refinance due to higher closing costs – e.g. appraisal costs, private mortgage insurance, pro-rata property taxes etc. It’s important to let you lender know of your refinancing concerns so that they can provide a service of extension and consolidation agreement. Ask your insurance company to offer you a discount as well.
Will it be difficult to get a Jumbo Loan then?
Generally (and thankfully), no. The process is pretty much the same. The only difference is that you have the bear the burden of choosing whether to put down a higher down payment, or bite the bullet and settle for a higher interest rate.
Of course in situations like these, you could look to a mortgage broker who has experience in types of rates that would be suitable to for someone in your financial position.
When getting a very large loan, it is more important than ever to shop, shop shop! That means go to different banks and lenders, make use of free consultations with mortgage brokers, to find out where you can get the lowest interest rate. You’ve seen how getting a large loan can bump your interest rates to the high heaves. So please do your due diligence!
I wouldn’t recommend such a large loan for new buyers. However, a larger loan maybe less of a problem if you’re more experienced with some cash flow lying around. It’s all a balancing act between down payment and interest rate here. Choose wisely!
Now, let me know – have you ever taken on a Jumbo Loan? What was your interest rate on it?