What is luxury home financing?
Luxury home Financing, envisaged always through mortgage loans, is a type of financing that exceeds the limits set by the Federal Housing Finance Agency (FHFA). Unlike conventional mortgages, Luxury home financing is not eligible to be neither purchased, guaranteed, nor securitized by Fannie Mae or Freddie Mac. Designed to finance luxury properties and homes in highly competitive local real estate markets, luxury home financing comes with unique underwriting requirements and tax implications.
If you have your sights set on a home that costs close to half a million dollars or more—and are not well-positioned in your bank account—you’re probably going to need luxury home financing, normally achieved through a jumbo loan. And if you’re trying to land one, you’ll face much more rigorous credit requirements than homeowners applying for a conventional loan or an FHA loan. That’s because luxury home financing carries more credit risk for the lender since there is no guarantee by Fannie Mae or Freddie Mac. There’s also more risk, apart from the lack of government guarantee, because more money is involved in these transactions.
Loan Limits In Luxury Home Financing
A luxury home financing is a mortgage used to finance properties that are too expensive for a conventional conforming loan. The maximum amount for a conforming loan is $548,250 in most counties, as determined by the Federal Housing Finance Agency (FHFA). Homes that exceed the local conforming loan limit require a specific luxury home financing.
The value of luxury home financing varies by state—and even county. The FHFA sets the conforming loan limit size for different areas on an annual basis, though it changes infrequently. As of 2019, the limit was set at $484,350 for most of the country. That was increased from $453,100 in 2018. For counties that have higher home values, the baseline limit is set at $726,525, or 150% of $484,350.
Also called non-conforming conventional mortgages, luxury home financing is considered riskier for lenders because these loans can’t be guaranteed by Fannie and Freddie, meaning the lender is not protected from losses if a borrower defaults.
Luxury home financing is typically available with either a fixed interest rate or an adjustable rate, and they come with a variety of terms.
Loan Requirements For Luxury Home Financing
Just like traditional mortgages, minimum requirements for luxury home financing, as nonconforming mortgage loans they are, have become increasingly stringent since 2008.
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Underwriting criteria for luxury home financing are stricter because the loans are larger and riskier for lenders.
Credit score
Lenders may require your FICO score or credit score to be higher than 700, and sometimes as high as 720, to qualify for luxury home financing.
Debt-to-income ratio
Although they are nonconforming mortgages, luxury home financing still must fall within the guidelines of what the Consumer Financial Protection Bureau considers a “qualified mortgage”—a lending system with standardized terms and rules, such as the 43% DTI.
Lenders will also consider your debt-to-income ratio (DTI) to ensure you do not become over-leveraged, though they may be more flexible if you have plentiful cash reserves. Some lenders have a hard cap of 45% debt-to-income ratio, however.
To become approved, you’ll need not only the superb credit score described above: 700 or above but also a very low debt-to-income (DTI) ratio. The DTI should be preferably under 45% and even better if it is around 36% according to some niche underwriters, but the average we recognize is right below 45%.
Cash reserves
You’ll need to prove you have accessible cash on hand to cover your payments, which are likely to be very high if you opt for a standard 30-year fixed-rate mortgage.
So you are more likely to be approved for luxury home financing if you have ample cash in the bank. It is not uncommon for lenders to ask luxury home financing borrowers to show they have enough cash reserves to cover one year of mortgage payments.
Documentation Required For Luxury Home Financing
Specific income levels and reserves depend on the size of the overall loan, but all borrowers need 30 days of pay stubs and W2 tax forms stretching back two years.
To prove your financial health and become suitable for luxury home financing, you’ll need extensive documentation, perhaps more than for a conforming loan. You should be prepared to hand over your full tax returns, W-2s, and 1099s when applying, in addition to bank statements and information on any investment accounts.
If you’re self-employed, the income requirements are greater: Two years of tax returns and at least 60 days of current bank statements. The borrower also needs provable liquid assets to qualify and cash reserves equal to six months of the mortgage payments. And all applicants have to show proper documentation on all other loans held and proof of ownership of non-liquid assets (like other real estate objects in your property).
Appraisals
Some lenders may require a second home appraisal for the property that you are planning to purchase.
Luxury Home Financing vs. Conforming Loans
The key difference between luxury home financing through a mortgage and a conforming loan is the size of the loan.
However, there are other differences. Among the other factors that differentiate luxury home financing from conforming loans:
Heftier down payment in luxury home financing
While low down payments are fairly common on conforming loans, jumbo loans are more likely to require a down payment of at least 20%, though some lenders may go as low as 10%.
Potentially higher interest rates
Mortgage rates in luxury home financing may be slightly higher than those on conforming loans, depending on the lender and your financial situation. However, many lenders can offer luxury home financing rates that are competitive with rates on conforming loans — and some may even offer slightly lower rates depending on market conditions, so make sure to shop around.
Higher closing costs and fees for luxury home financing
Because luxury home financing loans are bigger and there are some extra qualifying steps, expect higher costs at the closing table too.
Loan limits
The loan limit for conforming loans varies by county because some real estate markets are much pricier than others. For 2021, the conforming loan limit for one-unit homes in most counties nationwide is $548,250. However, in “high-cost areas,” especially in the Northeast and on the West Coast, conforming loan limits are expanded to $822,375 — and even higher in a few other places.
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In this market, cash is king. So far this year in Los Angeles County, excluding Beverly Hills and West Los Angeles, 35% of homes priced $2 million or higher were purchased using all cash, according to Multiple Listing Service data provided by the California Assn. of Realtors.
But when rich home buyers don’t have the liquidity to purchase their homes outright, many turn to massive mortgages known as jumbo loans.
The average borrower commonly uses a so-called conforming loan, which is backed and capped by the government. For most of the country, the limit is $424,100, but in pricey Los Angeles County, the maximum is $636,150, according to the Federal Housing Finance Agency.
Jumbo loans exceed the mortgage amount that Fannie Mae and Freddie Mac will purchase from lenders. Many experts blame the financing tactic for helping to enable the housing bubble by encouraging extravagant property purchases.
But in recent years, interest rates for jumbo mortgages have bucked expectations, said Lynn Fisher, vice president of research and economics for the Mortgage Bankers Assn.
“Historically, conforming loans are more liquid and are backed by government agencies, so from a supply-side point of view, they’re easier loans to make,” she said. “But since the crisis, we’ve seen a phenomenon where jumbo rates are as low and sometimes lower than conforming.”
Lenders have loosened the spigot for jumbo borrowers. Credit supply for jumbo loans surged 2.7% in July from the previous month, compared with 0.3% for conforming loans, according to a credit availability index from Fisher’s group.
High-net-worth home buyers are attractive to lenders because their substantial income and assets make them appear to be less of a default risk. And many banks offer the loans to entice premium clients.
“There’s a lot of advertising, a lot of competition to provide these loans right now,” Fisher said.
Still, from origination to payout, the jumbo-loan process can be vexing, especially for borrowers whose wealth is spread across different types of income, investments, inheritance and assets. Documentation is often extremely complicated.
“A lot of these borrowers can’t walk into a traditional bank and get a $5-million loan,” said Brandon Boyd, an executive mortgage consultant with Encinitas lender Drop Mortgage. “It’s hard for a bank lender to pull back and understand that income.”
Boyd said his company uses a more specialized approach, considering financial factors that might elude a bank relying on an automated screening system. In addition to common mortgage products, Drop also offers customized jumbo loans of up to $15 million.
Many clients — including entrepreneurs, film producers and athletes — aren’t focused on their day-to-day financials, resulting in less-than-stellar credit scores, Boyd said. Or they’re willing to pay a premium to protect their privacy by closing a sale through a limited liability company, which is prohibited for Freddie Mac and Fannie Mae mortgages.
Drop’s loans — most of which fall between $800,000 and $2.5 million — comply with government regulations and have yet to result in a default, Boyd said.
“It’s not irresponsible lending at all — it’s an alternative space, but it’s not the subprime of the past, not by a long shot,” he said.
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