FHA Loans vs VA Loan

FHA loans vs VA loans are often the most debated loan programs for eligible borrowers. Both loans are government-backed and have supportive aspects, but each program has its pros and cons.

Keep reading to learn which loan program may be right for you.

FHA Loans – What are They and How do they Work?

FHA loans are for borrowers with less than perfect credit, low income, or any other unique circumstances. Because the FHA guarantees these loans, lenders can have more flexible guidelines.

The Federal Housing Administration is a government agency that backs FHA-approved lenders. This means they promise lenders they’ll pay them back a portion of the funds they lost if an FHA borrower defaults on their loan.

This only occurs if the FHA lender follows the FHA guidelines, which fortunately has relaxed underwriting requirements.

The FHA doesn’t underwrite or fund the loans – only FHA-approved lenders handle that part. The FHA holds the guarantee for lenders though, so they can write loans for ‘riskier’ borrowers.

You don’t have to belong to a specific group or have a certain job to secure an FHA loan. It’s the most common program for borrowers that don’t qualify for conventional financing.

VA Loans – What are They and How do they Work?

VA loans are for veterans of the military or active members who served at least 90 days. In some cases, surviving spouses of veterans who lost their lives during or due to their service may be eligible too.

When you look at FHA loans vs VA loans, you’ll notice a large similarity – the VA guarantees VA loans like the FHA guarantees FHA loans. This is how VA-approved lenders can offer flexible guidelines for those who served our country.

VA loans have some more attractive features for veterans. For example, they don’t need a down payment, there isn’t a maximum debt-to-income ratio they must meet, and there isn’t mortgage insurance.

However, VA loans have funding fees for every loan you borrow. The funding fee goes directly to the Department of Veterans Affairs and is how they continue to guarantee loans for veterans. You can finance the cost in your loan, paying it over the 15 to 30-year term if you can’t afford it upfront.

Property Type – FHA Loans vs VA Loans

FHA loans and VA loans are similar in their property requirements. In both cases, the home must be your primary residence. This means you’ll live there year-round. You can have a second home (vacation home), but you must live in this property most of the year and you can’t rent it out.

The best option for borrowers looking to buy an investment home to either fix and flip or buy and rent out is a conventional loan. If this interests you, contact us and we’ll help you learn more.

Both FHA loans and VA loans require the home to be in safe, sound, and sanitary condition. Each loan program has specific Minimum Appraisal Requirements too. They aren’t anything too tough to meet and are in your best interests to ensure the house is a good investment.

Down Payments – FHA Loans vs VA Loans

A major difference between FHA loans and VA loans is the down payment requirements.

FHA loans require a 3.5% down payment. You may be eligible to receive the funds as a gift if you track them properly and follow the lender guidelines, but in general, you can only borrow up to 97.5% of the property’s value.

VA loans don’t require a down payment. You can borrow 100% of the property’s value, but this means you start homeownership with no equity. Veterans are free to put money down on the home even though it’s not required.

Loan Limits – FHA Loans vs VA Loans

Most loan programs have a loan limit or a maximum amount you can borrow, but VA loans are an exception.

FHA loans have loan limits that are based on where you live. The limit varies from $330,000 to $750,000 and is based on the average cost of homes in the area. If you live in a high-cost area, for example, you’ll have much higher loan limits, but if you live in a low-cost area, the limits will be much lower. There aren’t any exceptions to the FHA loan limits, so if you exceed those limits and are a veteran, you may want to look at the VA loan.

Like we said above, VA loans don’t have loan limits – the laws changed in 2020, allowing veterans to borrow as much as they prove they can afford. There is an exception, though. If you used your benefits before and defaulted, you’ll lose that portion of your eligibility, which means you can borrow less money, or if you borrow the same amount, you must make up the difference with a down payment.

Debt-to-Income Ratios – FHA Loans vs VA Loans

Your debt-to-income ratio is the percent of your monthly income spent towards paying off debt.

FHA loans have a maximum debt-to-income ratio of around 50%. However, if you have compensating factors, such as a high credit score or great loan payment history, lenders may be willing to accept a slightly higher DTI.

VA loans don’t have a maximum debt-to-income ratio. However, if you have a debt-to-income ratio higher than 41% you could be subject to a closer review of your finances.

Your debt-to-income ratio is going to be up for review no matter which loan you choose. Be open and honest with your loan officer to help him/her understand your situation and match you with the best loan.

Credit Scores – FHA Loans vs VA Loans

Your credit score is just as scrutinized as your debt-to-income ratio. Just like your DTI, you can find out your credit score and improve it before applying for a loan.  for a loan.

FHA lenders require a 580-credit score or higher if you want to make a 3.5% down payment. If you have a credit score between 500 – 579, though, you may still be eligible but with a 10% down payment.

VA loans don’t have a minimum credit score requirement, but most lenders want a higher credit score because of the 0% down payment the VA requires. Most lenders require at least a 620-credit score, but there may be exceptions.

If you have a lower credit score, even if you are a veteran, the FHA loan may be a better choice unless you have to compensate factors that allow a VA lender to approve your loan.

Mortgage Interest Rates – FHA Loans vs VA Loans

Borrowers always worry about the interest rates, but when comparing FHA and VA loans, there isn’t much comparison. They both offer competitive interest rates, but they vary based on your qualifying factors such as your credit score, debt-to-income ratio, location, and payment history.

To get the best interest rate, improve your credit score and debt-to-income ratio as much as possible. It’s also important to ensure you have enough assets to cover any required down payment or closing costs and you have stable employment.

Mortgage Insurance – FHA Loans vs VA Loans

Mortgage insurance protects the lender, ensuring they are reimbursed if you default on your loan.

This is an expense you don’t want to overlook.

FHA loans require mortgage insurance for every borrower for the life of the loan. FHA loans have an upfront mortgage insurance fee plus a monthly premium you must pay until the loan is paid in full.

VA loans do not require mortgage insurance. However, you’ll pay a funding fee when you take out the loan. The one-time fee ranges from 1.4% – 3.6% depending on how many times you’ve used your benefit, the reason for the loan, and your down payment.

When comparing your options, figure in the cost of mortgage insurance and/or the funding fee and look at the bottom line.

FHA and VA Loans – Pros and Cons

You have a lot to consider when choosing FHA loans vs VA loans. They aren’t a one-size-fits-all approach. Here are some pros and cons of each to consider.

FHA Loans

PRO: Lower credit scores are allowed with an FHA mortgage

CON: If you have a lower credit score your initial down payment or interest rate may be higher

PRO: Your loan will not be affected by the amount of time spent in the military

CON: You will pay mortgage insurance for the life of the loan

PRO: The FHA doesn’t have income limits you must meet to be eligible.

CON: There are borrowing limits based on where you live.

PRO: You need only 3.5% down on the home

CON: Credit scores between 500 – 579 require a 10% down payment

VA Loans

PRO: You don’t need a down payment

CON: You’ll need a credit score of at least 620

PRO: You will not need mortgage insurance

CON: Your time spent in the military can affect the amount you will receive, and if you have a dishonorable discharge, you aren’t eligible

PRO: The VA has much more lenient debt-to-income ratio requirements

CON: Most borrowers pay a hefty funding fee to get the loan

PRO: VA loans are assumable

CON: You’ll lose your eligibility if you defaulted on a VA loan before

VA Funding Fee

What is the VA Funding Fee?

The VA funding fee is a one-time payment that either veterans, service members, or survivors might pay on a VA home loan.

The funding fee helps lower costs taxpayers pay by making the program more affordable without any down payments and monthly mortgage insurance fees.

Will I have to pay the VA funding fee?

If you’re using a VA home loan to buy, build, improve or repair your home then it is likely that you will need to pay the funding fees as long as certain requirements are met.

VA Funding Fee – Purchase and Construction Loans

IF YOUR DOWN PAYMENT IS… YOUR VA FUNDING FEE WILL BE…
First use Less than 5% 2.3%
5% or more 1.65%
10% or more 1.4%
After first use Less than 5% 3.6%
5% or more 1.65%
10% or more 1.4%

VA Funding Fee – Cash-Out Refinancing

FIRST USE AFTER FIRST USE
2.3% 3.6%

VA Funding Fee – IRRLs and Other VA Home Loans

LOAN TYPE VA FUNDING FEE
Interest Rate Reduction Refinancing Loans (IRRRLs) 0.5%
Manufactured home loans (not permanently affixed) 1%
Loan assumptions 0.5%
Vendee loan, for purchasing VA-acquired property 2.25%

Refinance Loan Options

VA IRRL and VA Streamline Refinance

The VA IRRRL, which stands for “Interest Rate Reduction Refinance Loan,” provides qualified veterans the ability to quickly and easily refinance their mortgage into a lower interest rate and payment. The IRRRL is also known as the VA streamline refinance.

To qualify, you only need to prove a timely mortgage payment history (no late payments in the last 12 months). Most lenders don’t re-verify your income, assets, credit score, or home value. Every lender differs, though, so it’s important to discuss your options and see what lenders require.

The point of the IRRRL program is to lower your payment or change your term. It’s not a loan that helps you tap into your home’s equity. It’s strictly meant to make your loan more affordable or benefit you in some way.

FHA Streamline Refinance

The FHA program also offers a streamlined program similar to the VA IRRRL program. This program also helps borrowers secure more attractive financing.

For example, if you had a 580-credit score when you bought your home, but you’ve since improved it to 700, you may be eligible for a lower interest rate.

The FHA streamline refinance doesn’t require proof of your income, assets, credit score, or home value. It focuses on your payment history. If you made your last 12 payments on time and the new loan has a lower rate, you’ll save money and be even better able to afford the loan.

The Final Decision

As you can see there is not one specific loan that fits everyone’s needs. It’s best to contact a mortgage professional to discuss FHA loans vs VA loans.

As a veteran, you are likely drawn to the VA loan but it’s not always the right choice.

Many people struggle with low credit scores and a high debt-to-income ratio. These factors can make it difficult when applying for a loan.

If you have a low credit score, an FHA loan may be the best option. However, for veterans with good to excellent scores, it is hard not to argue in favor of VA loans

For help getting started with your VA Loan or FHA loan click here.

How do Tradelines Help my Credit Score?

Your credit score is one of the most important aspects of your personal finances. A great credit score can get you the best rates and terms on loans, including a mortgage. Your credit score is the first thing lenders look at when you apply for a loan, and it’s even used when you apply for new insurance or sometimes a new job.

Tradelines are what makes up a credit score. They are the meat behind the calculations and are something you should understand so you can boost your credit score.

What are Tradelines?

A tradeline is the credit account reported on your credit report. Anytime you apply for and get a new credit line, it’s reported to the credit bureaus (with a few exceptions). Each tradeline is a separate account. Even if you have multiple accounts with the same bank, each account is its own tradeline.

Types of Tradelines

There are two main types of tradelines – revolving and installment.

Revolving tradelines are credit cards or card lines. They are revolving because you can reuse the funds once you pay the amount borrowed back. Think of your credit card. Let’s say you have a $1,000 credit line and you charge $1,000. If you pay back $500 of it, your available credit becomes $500, because it’s revolving.

Installment tradelines have a fixed loan amount that doesn’t revolve. You receive the funds in one lump sum and pay the money back in a fixed payment of principal and interest. Common installment loans are car loans, personal loans, and mortgages.

What Information is Included in Tradelines?

No matter the type of tradeline you have, it includes quite a bit of information about you. The credit bureaus use this information to calculate your credit score and other lenders use the information to decide if you’re a good risk.

Tradelines include some or all of the following information.

Lender Information

This section displays information about the lender including the name and address. Sometimes the information is abbreviated, so you might have to do a little digging to realize which bank it is reporting on your credit report.

Type of Account

The type of account is either installment or revolving. This plays a role in your credit score because a good credit mix helps your credit score. It also shows lenders how much revolving debt you have available. Too much revolving debt could be risky because it gives you more opportunity to rack up credit card debt and get in over your head.

Account Number

The account number is usually abbreviated, showing only the last few numbers. Match up the numbers with your account to make sure it’s the right account when checking your credit.

Open or Closed

It’s not just open accounts that report on your credit report. Tradelines can stay on your credit report for many years. The open or closed status lets lenders know how much debt you have currently. If it’s closed, it may also state the reason (lender forced, consumer chose to close, paid off, etc.).

Dates

Tradelines show the date you opened the account and closed it, if applicable. This is important too because if you have too many accounts opened recently, you could pose a higher risk of default. Your credit’s ‘age’ also affects your credit score. The older your accounts are, the more it helps your credit score.

Original Balance

The original balance shows lenders how much you borrowed, and they can compare it to your current balance to see how much you’ve paid off. This also shows lenders the amount of your credit line for any revolving debt. Larger credit lines can pose a higher risk because you have more chances to charge more than you can afford.

Current Balance

This is the amount you currently owe. It helps lenders determine your debt-to-income ratio and how much debt you have outstanding. The lower your current balances are compared to your credit line for revolving debt, the better it is for your credit score.

Payment History

Your payment history is the largest part of your credit score (35%). This is where it reports if you made your payments on time or late. If you made payments late, they are reported in 30-day increments – 30 days late, 60 days late, 90 days late, or 120+ days late. The later your payments are, the more it hurts your credit score.

Required Monthly Payment

The required monthly payment shows how much you must pay each month. This also affects your payment history if you don’t make the full payment by each due date.

How do Tradelines Increase your Credit Score?

The information in your tradelines is what makes or breaks your credit score. If you use your tradelines wisely, they can help your credit score.

So how do they help? Here are the top ways to treat your tradelines to get the best credit score possible.

On-Time Payment History

Your payment history is the most important aspect of your credit score and is the number one way to boost your credit score.

An on-time payment history can increase your credit score fast. If you fall behind and have late payments, you can fix the issue by bringing your payments current and making future payments on time.

If you fall behind and can’t catch up, work with your lender to create a plan to better manage your debt. They might be able to adjust your due date or put you on a payment plan so you catch up and your credit can start benefiting from the on-time payments.

Low Current Balance Compared to your Credit Line

Your current balance plays a big role in your credit score too, mostly for revolving debts. If you have a large current balance, you might be at a high risk of default. For example, if you have a $5,000 credit line and have $4,000 outstanding already, you are a higher risk.

The credit bureaus calculate what they call your credit utilization rate. This is the comparison of your outstanding balance to your credit line. The lower your credit utilization rate is, the better it is on your credit score. The ideal ratio is 30%.

Don’t Close Accounts

You can close accounts at your own will, but having an account closed for you won’t help your credit score.

Ideally, you’d keep all accounts open to increase your credit age. The older your credit age is, the better it is for your credit score. Newer credit is risky because it doesn’t have a long history behind it. The older credit gets, the more information lenders and the credit bureaus have to use to determine if you’re a high risk of default.

Can Tradelines Hurt Your Credit Score?

Just as tradelines can help your credit score, they can hurt them too. Here are the top ways tradelines can hurt your credit score.

Late Payments

Late payments are the number one way to hurt your credit score. You can lose as much as 100 points with one late payment. How a late payment affects your credit score varies by situation, but it almost always causes a score to drop significantly.

High Balances

High balances are the next most important factor in your credit score. Your tradelines show how much money you have outstanding compared to your credit limits. High balances show the credit bureaus that you might not handle your finances well and it can hurt your credit score as a result.

Too Many Revolving Accounts

Having too many credit limits at your disposal can be risky. Since you can reuse the credit lines, you have a lot of credit available for use which could mean you put yourself in over your head in debt. The potential is there, even if you don’t do it, which could hurt your credit score.

Too Many New Accounts

Applying for too many accounts at one time can be hard on your credit score. New credit is risky because it’s a new debt you have to manage. There’s no history behind it so until you get established and the credit gets older, it will hurt your credit score.

How to Make Sure your Tradelines are in Good Standing

Tradelines are the only way to improve your credit score, but they must be in good standing to make it work. To make sure your tradelines are in good standing, do the following.

Pull your Free Credit Reports

Everyone gets free access to their credit reports weekly. Check yours often, looking for any errors (human or fraudulent) and any issues you can clear up. If you find incorrect information on your credit report, write a dispute letter to the appropriate credit bureau.

If you discover you missed a payment, overextended your credit, or made other mistakes, do what you can to fix the issue quickly to help your credit score bounce back.

Make your Payments on Time

Always make your payments on time. If you can’t, contact your creditor and work out a plan. Letting your account go unpaid without any communication with the creditor is the number one way to hurt your credit score.

If you fall behind, don’t assume it’s over. Your credit score can change monthly, so get back on track as quickly as you can to help your credit score increase.

Keep Your Credit Balances Low

Just because you have a high credit limit doesn’t mean you should spend all of it. At the most, you should have 30% of your credit limit outstanding, which is $300 for every $1,000 credit line. If you charge over 30% of your credit limit, make sure you can pay all or most of it off so that your credit limit has no more than 30% outstanding when the tradeline is reported to the credit bureaus.

Don’t Apply for Unnecessary Credit

It can feel like every day you’re bombarded with credit card applications or offers for great loans. Just because you’re presented with them doesn’t mean you need them.

Only apply for the credit you actually need and that makes sense for your credit score. Do your research on the product and take time to think about how it might affect your credit score. Don’t take on debt you aren’t 100% sure you can pay on time, and don’t use credit cards as an extension of your income.

Final Thoughts

Tradelines are the bread and butter of your credit score. It pays to take good care of them, understand how they work, and know how to use them to your advantage.

Pull your free credit reports often and take care of any issues that arise with your credit score to keep your credit in tip top shape.

How Paying Off Credit Card Debt Boosts Your Credit Score

If you carry a credit card balance or balances, you could be hurting your credit score and your chances of getting a mortgage approval. Your credit card balances, how you pay your credit cards, and even the number of cards you carry can hurt your credit score.

But paying your credit card debt down can help and anyone can do it. Here’s what you must know.

 

How Does Credit Card Debt Affect your Credit Score?

Credit card debt is the second largest part of your credit score. The first is your payment history.

The credit bureaus calculate your credit utilization rate or the amount of credit card debt you have outstanding compared to your total credit lines. They look at credit card lines individually and as a whole.

Ideally, you shouldn’t have a utilization rate over 30% or it hurts your credit score. This means for every $1,000 credit line, you shouldn’t have more than $300 outstanding. Of course, it’s always best to pay your balance in full, but if you can’t, keep the 30% threshold in mind.

If your credit utilization rate is over 30%, it can hurt your credit score significantly. If you combine it with late payments (payments made more than 30 days late), you could damage your credit score quite a bit.

 

Does Carrying a Balance Hurt your Score?

Carrying a credit card balance doesn’t automatically hurt your credit score. It depends on the balance. Like we said above, if you carry a balance that’s over 30% of your total credit line, it can hurt your score. If it’s less, it may not hurt your score as long as you make your payments on time.

That doesn’t mean it’s a good idea to carry a balance, though. Every time you carry a balance, you pay interest on those charges. This increases the total cost of your purchase and makes it harder to pay the debt off in full.

 

How Fast Does Paying off Credit Card Debt Help your Credit Score?

Any changes you make to your credit takes time – your credit score won’t change overnight. But, paying off your credit card debt consistently will definitely help boost it. If you pay the balance off completely, your score might change in as little as 30 days.

If you take a more methodical approach, it may take more time, but every bit helps. Even if your credit score only improves a point or two at a time, over time it will accumulate to a much bigger and more effective change.

How Much Does Paying off Credit Card Debt Help your Credit Score?

Paying off your credit card debt helps increase your credit score, but how much it helps differs. Each situation has a different outcome. There are typically 3 ways to pay off your credit card debt.

Pay the Full Balance

Paying your credit card balances in full will have the largest effect on your credit score. You’ll take your credit utilization rate down to 0%, which will help your credit score increase dramatically.

You won’t see the change instantly because it takes time for the new balance (or lack of a balance) to get reported to the credit bureaus.

To have the best effect on your credit score, don’t close your accounts after paying off the balance. Keep them open but refrain from using them.

Pay Monthly, But Methodically

If you don’t have the money to pay the balance off in full, pay the balance monthly, but consistently. Budget a specific amount of money for your debt and pay it each month. The consistent payments will bring the balance down, lowering your credit utilization rate and increasing your credit score.

The change in your credit score will be slower than if you paid the balance in full, but it will increase each month as you pay the balance down and lower your credit utilization ratio.

Focus on One Card

If you’d rather focus on one card at a time, you can help your credit score, but the change will be less dramatic. The credit bureaus figure your credit utilization rate in two ways:

By each card individually

With your total credit utilization totaling up all credit cards

If you pay off one card at a time, you’ll decrease your credit utilization rate for that card, which will have a small effect on your credit score. It’s not until you hit all the credit cards and pay them off that you’ll see the most change.

How to Pay off Credit Card Debt

It’s obvious at this point that you must pay off your credit card debt if you want to improve your credit score, so how do you do it?

While there’s no right or wrong way to pay off credit card debt, here are the two most popular methods.

 

Debt Snowball Method

The debt snowball method is a common method for those that need to see ‘quick wins’ to stay motivated to pay off their credit card debt. The debt snowball method works like this:

Order your credit cards from lowest to highest balance. Don’t pay attention to anything except the credit card’s balance. Ignore the APR, minimum payment, or anything else and focus only on the balance.

Work each credit card’s minimum payment into your budget. Always make the minimum payment for every credit card on time. This is non-negotiable and isn’t a part of your credit card debt payoff plan.

Figure out how much extra money you can pay toward the debt. Look at your budget and determine how much extra money you can pay toward a credit card after paying the minimum payments and your other required bills.

Pay the extra money toward the first credit card in line. This is the card with the lowest amount of debt. Keep paying the extra money you have budgeted plus the minimum payment to this card until it’s paid in full.

Once you pay off your first card, celebrate!

Take the money you paid toward the first card including the minimum payment and extra money paid toward the debt and add it to the minimum payment of the next card.

Keep repeating Step 6 until you are completely out of credit card debt.

This method works well for most people because you can see quick wins. Let’s say you have a $500, $1,500, and $3,000 credit card. You’ll work on the $500 credit card first. You’ll see how fast you can pay off that credit card, which will motivate you to keep going, paying off the higher balance credit cards too.

 

Debt Avalanche

If you’d rather focus on paying the least amount of interest possible rather than having ‘quick wins,’ try the debt avalanche method. This method focuses on a credit card’s APR and works like this:

Order your credit cards in order of APR, highest to lowest. You’ll focus on the credit card with the highest interest rate to create that avalanche versus a small snowball. It takes longer to see progress with this method, but you’ll save the most money.

Make each card’s minimum payment. This is non-negotiable and isn’t a part of the debt payoff plan. Make the payments on time so you avoid any late fees or accrued interest.

Budget so you have extra money to pay toward your credit card debt in addition to the minimum payments. You’ll focus this money on one credit card at a time.

Pay the extra money toward the first credit card in line. This is the card with the highest APR. Like we said earlier, you won’t see quick wins here, but it will decrease the total interest you pay.

Once you pay the first card, you have a big reason to celebrate. Your highest interest credit card is paid off in full!

Take the money you paid toward the first card and add it to the minimum payment of the next card or the card with the second-highest APR.

Keep repeating step 6 until you are completely out of credit card debt.

Tips for Credit Card Use After Paying off your Credit Card Debt

Once you pay off your credit cards, it’s important to know how to handle them so you don’t hurt your credit score again.

 

Don’t Close your Credit Cards

This is the most important tip. Don’t close your credit cards even when they have a zero balance. You need the ‘credit age.’ The longer the credit card is open, the older your credit age is, which helps your credit score.

Closing a credit card also increases your credit utilization. For example, if you still have a credit card with a balance, and you close a credit card with no balance, you decrease your total credit limit by the amount of the closed credit card. This increases your credit utilization rate and hurts your credit score.

 

Use Credit Cards only for Purchases you can Pay in Full

Using your credit cards methodically can help increase your credit score. The best way to use them is to charge the things you normally pay for each month and pay the balance in full.

For example, you buy groceries, pay utilities, and pay for insurance each month. If you charge them and then pay the balance off before the due date you’ll help your payment history, which is the largest part of your credit score.

 

Lock your Credit Cards up if you’ll Use Them

If you know you’ll be tempted by your credit cards but don’t want to close them, lock them up somewhere safe. A safe deposit box or a safe at home are good places. You could also give them to a trusted family member to lock up for you and to keep you accountable. You’ll get the credit age without worrying about racking up credit card debt and ruining your credit score.

Don’t Use your Credit Card as an Extension of your Income

Too many people use credit cards to buy things they can’t afford. This isn’t how they should be used. They aren’t an extension of your income, but rather a tool to help you build credit, protect your purchases, and make the most of your finances.

Final Thoughts

Paying off credit card debt is one of the best ways to help your credit score and to help improve your chances of mortgage approval.

Credit card debt that gets out of hand can be expensive and detrimental to any other financial goals you have. Put a plan in place to get out of credit card debt and then don’t use your credit cards as an extension of your income, but instead a personal finance tool that helps you build credit rather than ruin it.

Mortgage Rates and the Fed: How Interest Rates Impact Mortgage Rates

Most of us know that mortgage rates rise and fall, but we do not have much of an idea about what causes that to happen.

While there are many factors that contribute to mortgage interest rates, the actions of the Federal Reserve can directly impact mortgages and their respective interest rates.

Read on to learn more about why your mortgage rate could be higher or lower based on what the Fed is doing.

What Is the Federal Reserve?

Before we dive into the Fed’s impact on interest rates and mortgages, let’s take a moment to review what the Federal Reserve actually is. The Federal Reserve is the central bank of the United States. It’s not controlled by the government, but it does have the task of managing the country’s currency and monetary policy, as well as keeping the economy stable.

These responsibilities mean the Federal Reserve impacts nearly every facet of your economic life. They influence credit card interest rates and business loan rates. They can also control how much you have to pay for everyday items since they are charged with keeping a handle on inflation.

What Are Interest Rates?

Many of us hear about interest rates for all sorts of things. We have interest rates on our credit cards, student loans, car loans, mortgages, and savings accounts. But what are interest rates, and how do they work?

Interest rates are effectively fees that the bank charges or pays you for the lending of money. When you pay interest on a car note or a mortgage, you’re paying the bank a small percentage of the loan amount for the privilege of borrowing their money. The interest you earn on savings accounts is payment from the bank for the privilege of using your money to finance other transactions.

Federal Funds Rate

When you hear about the Fed cutting interest rates, however, that refers to the interest on overnight reserve loans. These are loans banks give to each other overnight to meet mandated reserve levels. Borrowing and lending banks negotiate their interest rates individually, with the Federal Reserve as a guide.

The rate indices shown here are provided by the Optimal Blue Mortgage Market Indices (OBMMI) and are calculated from actual locked rates with consumers across more than one-third of all mortgage transactions closed nationwide. They do not reflect APR (Annual Percentage Rate) offered by Choice Home Mortgage. Your actual rate and loan terms will be determined by your creditworthiness and other factors.

The Federal Reserve recommends a certain interest rate for these loans, and in general, that recommendation is followed. The Fed may also take actions to help banks meet these federal funds rate goals. And while the Fed is not directly cutting your interest rates, these rate cuts can impact your finances.

Tools of Monetary Policy

Interest rates on overnight reserve loans are only one of a variety of tools of monetary policy the Fed has at its disposal. In essence, these tools are used to meet the Fed’s stated goals. They use these tools to keep prices stable and economic growth sustainable over the long term.

For example, when the Fed lowers overnight reserve loan interest rates, it allows banks to lower their interest rates for loans to their customers. These lower interest rates may inspire customers to take out more or bigger loans, funneling more money back into the economy. The Fed can use interest rate adjustments like this the same way you might turn on and off a tap – raise rates a little when economic growth is moving too fast and lower it a little when things need a boost.

Why the Fed Raises Interest Rates

It may sound strange that the Federal Reserve would want to slow down economic growth. After all, more money moving through the economy seems like a good thing, right? But if the economy grows too much too fast, it can become unsustainable and lead to a market crash.

On the flip side, keeping interest rates too high can slow down economic growth. Consumers wait to buy houses, keep driving old cars, and avoid large purchases. The Fed plays a delicate balancing game with how much economic growth they encourage at one time.

Open Market Operations

One of the ways the Fed can make sure banks hit the target interest rates is through a tool called open market operations. In simplest terms, this is when the Federal Reserve buys and sells government bonds as a way to funnel money into or out of the economy. A bond is a note you can buy from a government with a promise that, when the bond reaches maturity, you can sell the bond back for face value, plus the interest that has accrued on it in the meantime.

When the Fed wants to see more economic activity and lower interest rates, it buys back bond notes. This introduces more money into the system and encourages banks to drop their interest rates for overnight reserve loans. If they need to tighten things up a little, they sell more bonds, drawing more money out of the system.

Other Monetary Policy Tools

The Fed also has several other tools at its disposal to make sure bank interest rates hit targeted goals. For one thing, they can tweak bank reserve requirements to make them higher or lower. A reserve requirement is how much money a bank must have in the vault at night in order to guarantee the funds in their accounts.

The Fed can also adjust the terms on which it lends to banks to make them more or less stringent. It can adjust the interest rate it pays on the bank reserves it has on deposit. All of these adjustments effectively control the flow of money in and out of banks and the economy.

The Ripple Effect

So why should it matter to you if the Fed is changing the amount of money your bank has to have in its vault at night? Let’s say you have a checking account and a retirement savings account with Yourtown Bank. The fed lowers the amount of money Yourtown Bank has to have in reserve every night and lowers the interest rate goals for those reserve loans from other banks.

Now Yourtown Bank has a little more breathing room to work with the money they have. In the interest of keeping their customers happy, they decide to lower their own loan interest rates and increase the interest rates on that retirement savings account you have with them. Not only are you making more money towards your retirement now, but you can also buy a house at a lower mortgage interest rate.

How Mortgage Rates and Fed Rates Interact

The relationship between mortgage rates and the Fed interest rates is complex to say the least. In many cases, the system works as we’ve discussed. The Fed raises or lowers rates, banks follow suit, and you see mortgage rates fluctuate accordingly.

But banking doesn’t operate in a vacuum, and people are constantly speculating whether Fed rates will go one way or another. Certain high-level officials will let hints slip in public speeches, and banks take notice and adjust their mortgage rates based on that speculation. The Fed interest rates may then follow that adjustment or even adjust the opposite way to compensate for it if it moves too far beyond what they want.

Current Federal Funds Rate

You may not be surprised to learn that the COVID-19 pandemic has had a major impact on the Fed interest rates. On March 15 of this year, the Fed agreed to drop rates a full percentage point as an emergency response to the pandemic. The hope with this move was to stimulate a faltering economy and get more money moving through the system.

As of this writing, federal fund rates are sitting around a target of 0 to 0.25 percent. The Fed plans to keep these rates near zero until they are certain the economy has fully stabilized. This may mean lower interest rates for quite a while, since scientists are predicting a second wave of the coronavirus to hit sometime this fall.

How Financing Works

So now that we understand a little about how the Fed’s decisions impact your mortgage rate, let’s talk some about how mortgage financing works. Most of us think of a mortgage as a loan that we use to pay off a house. But in fact, a mortgage is a specific agreement that allows your lender to take possession of your home if you fail to pay off your mortgage in the specified time.

How much interest you have to pay on your mortgage depends on a few factors. The bank will look at things like your debt to income ratio, your recent income, and, of course, your credit score. This last item is a rating of how much you can be relied upon to pay your debts on time.

If you have a very high credit score and excellent credentials in the other areas that banks evaluate, you may be eligible for a prime lending rate. Unlike normal mortgage rates, this rate is directly linked to the Fed’s target rate for bank reserve loans. In general, you’ll pay 3 percent more for a prime mortgage rate than the Federal Reserve target rate.

Right now, if you qualify for a prime lending rate, you’ll be paying very close to a flat 3 percent. Over the lifetime of a loan, this could save you thousands of dollars, especially if you have a fixed-rate mortgage.

How Much Higher Rates Impact Mortgages

So let’s say you buy a house for $500,000 with a 3 percent fixed interest rate next month. In July 2018, that rate was around 4.8 percent. How much difference could a couple of percentage points really make?

If you pay $2,623 every month on your half-million-dollar home for thirty years, you’ll wind up paying nearly a million dollars for the house by the time you get done paying off the interest. But if you get that interest rate locked in at 3 percent, over the lifetime of the loan, you’ll pay just $758,887. That means you’ll save more than $185,000 by buying now, and you’ll be able to buy a cute vacation cottage with the money you saved.

Lower Interest Rates, Higher Prices?

It may seem counterintuitive at first, but lower interest rates could actually mean higher house prices. A lot of people will be looking at that $185,000 figure and doing the same math you are. This means there will be a lot of people trying to buy houses while rates are so low (which is part of the Fed’s goal).

An influx of demand for houses makes the real estate market a seller’s market. People selling houses will have an easier time moving them, meaning they can raise prices.

The Current Housing Market

If you’re considering moving houses or refinancing your mortgage, this is the perfect time to do it. You may have an easier time moving your home than usual since buyers are so much more motivated to snag these low interest rates. You can also set the price a little higher, get a little more from the sale, and lock in your own lower interest rate.

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However, it is important to remember the impact COVID-19 is having on the market. While it is true that interest rates are at historic lows, people are hesitant to go tour a bunch of houses due to the risk of exposure. If you can set up virtual tours of your house, you may have an easier time moving it.

Learn More About How Interest Rates Impact Mortgages

Understanding how Federal Reserve interest rates impact mortgages can be tricky, to say the least. Just remember, when the bank is being charged higher rates, they’re likely to pass those expenses on to you, and vice versa. And if you’re planning on buying or selling a house soon, it’s a good idea to act quickly and lock in these low mortgage rates.

If you’d like to get help in managing your new mortgage, check out the rest of our site at Choice Home Mortgage. We provide flexible mortgage products, an easy process, and quick service to make your mortgage or refinance as easy as possible. Apply now and start saving for your future today.

California Conventional Loan Limits 2022

Increased home prices and higher demand for more homes fueled a major surge in not only home values but also conforming loan limits. Government regulators realized the changes that were necessary to make homeownership possible for more borrowers. As a result, California’s 2022 conforming loan limits are increasing to $647,200, an increase of $98,950.

“With the recent run-up in-home price appreciation affecting many markets throughout the country, we wanted to step in and provide support for borrowers,” said Kimberly Nichols, Senior Managing Director of Broker Direct Lending at PennyMac. “This will specifically help those trying to purchase a home or access equity in their property while rates are relatively low.”

The industry is also predicting an increase for high-cost areas such as LA County and Orange County in California to be raised from $822,375 to $970,800 in 2022.

Even though the increase isn’t official until 2022, several lenders have jumped the gun and are already writing loans exceeding the 2021 conforming loan limit of $548,250 because of the high increase in home values this year.

Higher conventional loan limits are only a month away, but right now we may be able to find you a lender that is already using the 2022 conforming loan limits until they become the norm for every lender in 2022.

 

California 2022 Conventional Loan Limits

Just as the nation’s conventional loan limits will increase, so will California 2022 conventional loan limits. The ‘average’ conventional loan limit in California for 2022 will be $647,200 just like it is in other areas of the country.

This is the standard limit, that if you exceed, you’d need jumbo financing to buy a home. However, in certain areas of California, there are higher costs, and the areas have higher limits as a result.

Some of the high-cost areas of California include:

  • Alameda – $970,800
  • Contra Costa – $970,800
  • El Dorado – $675,050
  • Los Angeles – $970,800
  • Marin – $970,800
  • Monterey – $854,450
  • Napa – $897,000
  • Orange – $970,800
  • Placer – $675,050
  • Sacramento – $675,050
  • San Benito – $970,800
  • San Diego – $879,750
  • San Francisco – $970,800
  • San Luis Obispo – $805,000
  • San Mateo – $970,800
  • Santa Barbara – $783,150
  • Santa Clara – $970,800
  • Santa Cruz – $970,800
  • Solano – $647,200
  • Sonoma – $764,750
  • Ventura – $851,000
  • Yolo – $675,050

Unless you buy a home (or live in) a high-cost area, conforming loan limits of $647,200 prevail. If you need to borrow any more than this amount, you’ll need a non-conforming or Jumbo loan that may have higher interest rates and/or tougher qualifying requirements. Fortunately, many counties within California have higher limits because of the high cost of living there.

If you can fit your loan needs into the loan limits for the county you’re buying a home or refinancing a mortgage, you can still take advantage of the conforming loan with its more relaxed guidelines, lower down payment requirements, and lower costs.

Before you jump into a jumbo loan and jump through the hoops involved, let us help you determine if a conventional loan will be a better option.

How Do California 2022 Conforming Loan Limits Work?

Conventional loan limits pertain to conforming loans, aka Freddie Mac and Fannie Mae loans. All loans that fall within their guidelines ‘conform’ to the Fannie Mae or Freddie Mac rules. These loans have the benefit of backing by Fannie Mae or Freddie Mac which means if a borrower defaults, the lender won’t lose all the money invested in the loan.

Freddie Mac and Fannie Mae have loan limits to keep the risk within reason. With loan limits in place, they can avoid backing loans for riskier borrowers but still offer flexible loan guidelines. While you need good credit and a decent debt-to-income ratio, it’s just as easy to qualify for a conventional loan as it is the government-backed counterparts including FHA, VA, and USDA loans.

FHA, VA and USDA loans have lower loan limits than the 2022 conforming loan limits in some cases, though, depending on where you live. We can help you decide which loan is best for you, though.

Fannie Mae or Freddie Mac Loan

You must borrow within the conventional loan limits to qualify for a Fannie Mae or Freddie Mac loan, and meet these guidelines:

  • Minimum 3% down payment for first-time homebuyers or 5% for subsequent homebuyers. If you’re refinancing, you’ll need at least 5% equity in the home.
  • Borrowers need decent or even good credit scores. The score required varies, but in general, you should have a 660+ credit score to qualify and get the best interest rates.
  • Borrowers need a low debt-to-income ratio. This is a comparison of your gross monthly debt (income before taxes) and your current debt obligations (plus the new mortgage). Your DTI shouldn’t exceed 43%, which means your debts with the new mortgage shouldn’t take up more than 43% of your monthly income.
  • Proof you can afford not only the monthly payments, but the down payment and closing costs too.
  • Any compensating factors that make up for a lower credit score or higher debt ratio are important too. For example, a credit score below 660 doesn’t automatically disqualify you, especially if you have a large number of assets on hand or an exceptionally low debt ratio that helps you qualify.

If you don’t buy a home that falls within the 2022 conventional loan limits, you’ll need a non-conforming loan. This isn’t’ a ‘bad thing,’ but it can be more expensive and harder to qualify for which is why it’s good news that California conventional loan limits increased for 2022 to accommodate the higher loan values.

 

Who Qualifies for a Conforming Loan?

To qualify for a conforming loan, you must meet the above guidelines. However, there is one other major factor you must consider.

You must have the income you can prove beyond a reasonable doubt. Conforming loan lenders must prove they did their due diligence to determine you can afford the loan.

With the higher conforming loan limits, it will be a little harder to qualify for loans because you must prove you can afford them. We are here for you every step of the way to find you the loan you can afford and that offers the best terms.

What does that mean today?

You must prove you have a steady and consistent income. Working for an employer and producing paystubs and W-2s is the easiest way to get approved. But even if you’re self-employed you may qualify as long as you can prove steady income.

Borrowers that wouldn’t qualify are those with inconsistent income, or who can’t prove their income. You must be able to prove your income beyond a reasonable doubt to afford the higher loan limits.

What Conforming Loan Programs can you Use?

Conforming loans are conventional loans or those backed by Fannie Mae or Freddie Mac. They must meet the above loan limit guidelines and the qualifying guidelines for the loan program.

The basic conforming loan programs include:

  • Fixed-rate loans – 10, 25, 20, 25, and 30-year fixed-rate loans
  • ARM loans – 5/1, 7/1, or 10/1 ARM loans

Like we said above, you need ‘good’ qualifying factors to qualify for conforming loans. This means you have good credit, money to put down, and a decent debt-to-income ratio. The requirements seem ‘strict’ but they are flexible and great for first-time homebuyers and subsequent homebuyers.

Borrowers can choose which loan term they feel most comfortable with and can afford. Keep in mind, ARM loans are more affordable initially, but then the rate adjusts annually. For example, if you borrow a 5/1 ARM loan you have a fixed rate for 5 years and then it adjusts annually, based on the chosen index and margin.

Why Consider Conventional Loans?

Conventional loans are the most flexible programs because of government backing. If you need to borrow more than the limits allowed for your county, you’ll need a jumbo loan. If you can’t get a conventional loan because you don’t qualify, it’s worth fixing your qualifying factors so you do qualify and can get a conventional loan.

Here are a few reasons why:

  • Lower down payments – While a down payment is an investment in your home, you don’t want to put all your liquid assets into it. The money remains tied until you do a cash-out refinanceor sell the home, neither of which you’ll likely want to do anytime soon.
  • Easier appraisals – Many Fannie Mae and Freddie Mac loans need limited appraisals or are even eligible for appraisal waivers. They don’t have any strict requirements for the properties and the appraisal doesn’t usually hold up the loan process like it used to.
  • Flexible underwriting guidelines – The underwriting guidelines as a whole are flexible with conventional loans. If you can borrow within the increased conventional loan guidelines, you’ll have simple qualifying requirements that are flexible especially if you have compensating factors.
  • Low-interest rates – Conventional loans have some of the lowest interest rates in the industry. With today’s rates and the higher conventional loan limits, you can secure an affordable loan.
  • Fast closings – Conventional loans aren’t hard to get from application to the closing table. With an experienced lender, you can get it done in less than 30 days, making you a homeowner fast!

What if you Don’t Fit in the Conventional Loan Limits?

If you don’t meet the conventional loan limits, even in higher-cost areas, you’ll need a non-conforming loan, such as a jumbo loan. Jumbo loans have slightly stricter underwriting guidelines because they offer loan amounts in the $1 million range or higher.

What is the Jumbo Loan Limit in 2022?

In 2022, any loan exceeding $647,200 falls under the jumbo category. However, there are exceptions in certain counties within California. If you live in a high-cost county, the 2022 California conforming loan limits are higher.

If you live outside of the high-cost counties, though, you’ll need jumbo financing for any loan over $647,200.

How to Qualify for a Jumbo Loan?

If your loan needs exceed the California 2022 conventional loan limits, you’ll need to know how to qualify for a jumbo loan.

To qualify, you’ll need good qualifying factors to ensure your approval including:

  • High credit scores
  • Down payments of 20% – 30%
  • Stable employment and income
  • Low debt-to-income ratios

Jumbo loans don’t follow any government guidelines, so lenders can have their specific requirements. They usually have interest rates slightly higher than conventional loans too. When you’re borrowing a large loan amount, even 1/8th of a point difference can make a difference of thousands of dollars in interest.

 

What if you Don’t Qualify for a Conventional Loan?

If you don’t qualify for a conventional loan, there are other options with more flexible guidelines including the government programs, FHA, VA, and USDA loans. You must meet certain guidelines to be eligible for these programs, but their underwriting requirements are more flexible.

FHA Loans

FHA loans are the most flexible loan program available today. You don’t need a specific income or to belong to a certain group to be eligible. Anyone who doesn’t qualify for conventional financing typically turns to the FHA program.

Its guidelines are more flexible including:

  • Minimum 580 credit score
  • Minimum 3.5% down payment
  • Maximum debt-to-income ratio of 43%
  • Proof you’ll occupy the home as your primary residence
  • Stable income and employment for 2 years

FHA loans have different loan limit guidelines, but like conventional loans, they rarely exceed the California 2022 conforming loan limits except in certain California counties.

VA Loans

VA loans are another government program, but they are for a limited audience. To be eligible you must have served in the military or be a spouse of a deceased military member who lost his/her life during service.

If you served enough time and have VA home loan benefits, you can use this beneficial loan program which doesn’t require a down payment and has no loan limits. As long as you can prove you can afford the payment and you have full entitlement, you may qualify.

VA loan guidelines are flexible like FHA guidelines including:

  • Minimum 620 credit score
  • Maximum 43% – 50% debt ratio
  • Proof you’ll occupy the property as your primary residence
  • Proof you have enough disposable income for your family size and location
  • Stable income and employment for 2 years
  • Proof of your VA entitlement

USDA Loans

One last government-backed loan is the USDA loan. This program is for borrowers with low to moderate-income and who will live in rural parts of California as determined by the USDA guidelines.

USDA loans don’t require a down payment and have flexible underwriting guidelines too including:

  • Minimum 640 credit score
  • Maximum 41% debt ratio
  • Proof you’ll occupy the property as your primary resident
  • Proof you don’t qualify for any other loan program
  • Stable income and employment for 2 years

How are FHA Loans Different from Conforming Loans?

Many people wonder what’s different between FHA loans and conforming loans. While they have many similarities, there are differences too including:

  • Conforming loans require higher credit scores than FHA loans. You can get an FHA loan with a credit score as low as 580, but you’ll need at least a 660 to get a conforming loan.
  • You can use conforming loans to buy any type of property including second homes or investment properties. To use FHA financing, you can only buy a primary residence (the home you’ll live in full-time).
  • FHA loans charge mortgage insurance for the life of the loan no matter your loan-to-value ratio. Conforming loans only charge mortgage insurance while you owe over 80% of the home’s value. Once you pay the loan balance down, you can request cancellation of the Private Mortgage Insurance.
  • FHA loans cater to borrowers with good buying power but whose credit score or credit history makes them an unlikely candidate for a conforming loan.
  • FHA loans have different loan limits than conventional loan limits. The FHA loan limit in most California counties is $356,352 and in high-cost counties, it’s $822,375, but this may change as we enter the new year as well.

Do Conventional Loan Limits Change?

Every year, the Federal Housing Finance Agency looks at conventional loan limits. They determine the conventional loan limit and high-cost limit in certain areas based on the median cost of homes in the nation and specific areas.

Bottom Line

The California conventional loan limits change annually – and they typically increase as we see with the California 2022 conforming loan limits. This makes it easier for borrowers with all qualifications to secure conventional financing.

Jumbo loans can be harder to secure because of the risk they involve. Only borrowers with great credit, low debts, and a lot of assets qualify, which rules out the general population. Fortunately, with higher conventional loan limits, loans are easier to get in California, making homeownership a reality for millions of people.

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What is a Jumbo Mortgage Loan?

If you’re in the market to buy a home, but need a loan for high amounts, you may need a jumbo loan. The name sounds ominous, and most people believe jumbo loans are impossible to qualify for or are too expensive. Neither is true. Jumbo financing is a great financial tool if you’re in the market to buy a home that exceeds the standard loan limits.  Here’s everything you must know about jumbo financing, how it works, and whether it’s right for you.

What is a Jumbo Morgage Loan?

A jumbo loan is financing for a home that’s higher than the conventional limit. In 2022, the conventional loan limit is $647,200. Any loan higher than this amount requires jumbo financing or non-conforming financing.

The exception to this rule is high costs areas such as California. For example, in Los Angeles, the conventional loan limit for 2022 is $970,800

The premise is the same for conforming and non-conforming loans – you must qualify for financing, but because it’s unconventional, there aren’t any government agencies backing up the lender. Fannie Mae and Freddie Mac back up or guarantee conventional loans. If a borrower defaults, they have the bank’s bank, ensuring they don’t lose their neck on the deal.

Jumbo lenders don’t have this guarantee which is why they have tougher requirements to ensure you can afford the higher loan payment and terms. It’s a precaution for you and the lender. You don’t want to get into a loan you can’t afford as much as they don’t want to lend you the money you can’t afford to pay back.

How Does a Jumbo Mortgage Work?

Jumbo financing works on all home types including single-family homes, condos, and townhomes. You can use the financing to buy a home or refinance an existing home. You can even use it as a cash-out loan, tapping into your home’s equity.

Jumbo Loans for a Home Purchase

Just like any loan, you must prove you qualify for the loan to use jumbo financing for a home purchase. Most jumbo loans are available from $548,251 to $2.5+ million. It’s possible to borrow more than $2.5 million too, but with even tougher qualifying requirements since the risk of default increases with the loan amount.

Jumbo Loans for a Rate and Term Refinance

A rate and term refinance are a refinance to either lower your interest rate or change the loan’s term to make it more affordable. In 2021, for example, millions of people refinanced their loans because interest rates dropped so low, even for jumbo loans. It was a great opportunity for many people to save money on interest and/or make their loan payments more affordable after a difficult year.

The rate and term refinance are also great for those who need a different term. Whether you took a 15-year term but it’s more than you can afford or you took a 30-year term but can afford more now, you can take advantage of the current low rates and refinance the loan.

With the jumbo rate and term refinance, you don’t take any cash out of your home’s equity. You simply restructure your loan so that it’s more affordable or to help you save money on interest over the life of the loan. 

Jumbo Loans for a Cash-Out Refinance

If you have equity in your home (you owe less than the home’s value), you may tap into it with a cash-out refinance.

Unlike conventional loans, though, you’ll need more equity before you can tap into it if you need a jumbo loan. The amount varies, but, you’ll need at least 30% equity before you can take equity out of your home.

Cash-out refinance loans have higher interest rates and tougher qualifying requirements because of the risk they cause. But if you’ve invested most of your money in your home and now need it for an emergency or future expense, a cash-out refinance may be an option.

How to Qualify for a Jumbo Loan

The question everyone wants to be answered is ‘how do I qualify for a jumbo loan?’ You know the requirements are tougher, but what do you need? Here’s a quick breakdown.

Minimum Credit Score

The exact credit score you need varies based on your loan amount and qualifying factors, but in general, borrowers need a 700+ credit score.

In other words, you need great credit to get jumbo financing. Again, it’s to account for the risk jumbo loans create. A borrower with a great credit score poses a lower risk of default which means you’re less likely to end up in foreclosure.

If you don’t have a 700+ credit score, you may still qualify if you have compensating factors or factors that make up for the risk a lower credit score creates.

Maximum Debt-to-Income Ratio

The next largest factor when determining your eligibility for a jumbo loan is your debt-to-income ratio. This compares your gross monthly income to the debts you have outstanding plus the new mortgage.

The DTI measures how well you can afford the mortgage. A high DTI means you may not be able to afford the mortgage, and a low DTI means you have more affordability and are at a lower risk of default. 

The exact DTI needed varies by borrower, but overall, a 40%-45% DTI is the maximum most borrowers can have to secure jumbo financing.

Employment Verification

If you’re employed by someone, you must be able to prove your employment with paystubs, W-2s, and a verbal/written Verification of Employment. If you are self-employed, you must provide proof of your income with your bank statements and tax returns. You’ll also need a statement from a third party, such as your CPA stating you are self-employed and the income you reported is accurate. 

Asset Verification

All borrowers must prove their assets by providing the last couple of months of bank statements. The bank statements must show the assets you claimed on your application and the deposits should be in line with the income you claim too. If there are large deposits, you may need to write a Letter of Explanation to explain where the deposits came from and to prove they are not funds from another loan.

Cash Reserves

Some borrowers need cash reserves to qualify for jumbo financing. Reserves are money you have set aside ‘just in case.’ If you lost your job or had other financial issues, the cash reserves could help cover your mortgage payments. Cash reserves are calculated based on the number of mortgage payments it could cover.

For example, if your mortgage payment is $2,000 and you have $16,000 in reserves, you have 8 months of mortgage payments set aside. This can help your chances of loan approval. 

Appraisal

All jumbo loans require an appraisal and the appraisal must state the home is worth at least as much as you agreed to pay if you’re buying the home. If you’re refinancing, it must be worth enough for you to refinance your current loan and still have the required amount of equity in it.

Sometimes jumbo financing requires a second appraisal to ensure the first appraisal was an accurate reflection of the current market rates. 

Jumbo Loans vs Conforming Loans

Since you must jump through a ton of hoops to get jumbo financing, you may wonder how it differs from conforming loans since they too have strict requirements. Here are the largest differences.

Credit Scores

Conventional loans are usually more lenient than jumbo loans because there’s less at risk and Fannie Mae or Freddie Mac backs up the loan. While you still need good credit, it doesn’t need to be perfect.

Loan Amount

The largest difference is the loan amount (the amount you can borrow). Conventional loans only go up to $548,250 (except for certain high-cost areas), whereas jumbo loans go much higher. Both loans, however, only allow you to borrow the amount you can afford. The limits are a generalization and aren’t a guarantee that you can borrow as much.

Stricter Underwriting Guidelines

Jumbo financing has stricter underwriting guidelines including a larger down payment, lower debt-to-income ratio, and more cash reserves. Both loans use compensating factors to make up for a ‘bad factor,’ such as a low credit score or high DTI, but jumbo financing may be less forgiving than conventional. 

 

Pros and Cons of the Jumbo Loan

Like any mortgage financing option, there are pros and cons of the jumbo loan that you should understand.

Pros

  • You can borrow more money, allowing you to buy a more expensive home. This is helpful especially in high-cost areas where the home prices greatly exceed the conforming loan limit.
  • You can avoid taking out two loans as conforming loans would require. With two loans, you’d need a first loan for 80% of the sales price and a second loan, such as a home equity loan for the remainder minus your down payment.
  • There are many loan options including fixed-rate and adjustable-rate loans, as well as 15 – 30 year term options, giving everyone a chance to choose the loan that suits them.
  • Jumbo loans still have the flexibility and great interest rates. As long as you work with a quality lender, you’ll get the same flexibility you’d get on a conventional loan.

Cons

  • You need great credit. A 700-credit score is typically the lowest you can have to qualify for the financing, which for some people is unachievable.
  • You need a lot of cash reserves. Conventional loans don’t require cash reserves for most borrowers, but jumbo financing may require reserves of 3 to 6 months of mortgage payments for you to qualify.
  • You need a large down payment. This ties up your money in your home which isn’t liquid. If you need to access the cash, you’ll need to qualify for a mortgage refinance or sell the home.

Are Jumbo Loan Interest Rates Higher?

Everyone wants to know about the interest rates. If the risk is higher on a jumbo loan, the rates are likely higher too, right?

They could be, but it’s not a necessity. When you work with a quality lender, you may secure competitive interest rates compared to conventional loans. The key is having great qualifying factors.

The lower your credit score and debt-to-income ratio, the higher your chances of securing a low-interest rate. If you have less-than-perfect qualifying factors, determine what compensating factors you may have that can offset the risk so you can secure the competitive interest rates.

Is a Jumbo Loan Right for You?

If you’re buying a home in an expensive market and don’t have the down payment to bring your financing needs below the conventional or high-cost limit you’ll need jumbo financing.

It’s not right for everyone since it is more expensive. Even with low-interest rates, the principal payment itself is higher than a traditional loan, so exercise caution before taking out a jumbo loan.

Make sure you can afford the payment not only today but, in the future, too. You’ll likely have the mortgage for 15 – 30 years, so think about your future. Will you have the same income or higher? Will you go down to one income when you start a family? Do you want a mortgage that takes up a large portion of your income?

Answering these questions honestly can help you choose the right mortgage. If you decide jumbo loans are the way to go, work with a reputable lender that offers competitive interest rates, forgiving guidelines, and exceptional service. A mortgage is one of the largest personal finance decisions you’ll make in your lifetime so make sure it’s an informed decision.