Why would a bank give a lower loan rate to someone who wants to buy an expensive home? If they can afford a higher priced home, can't they afford a higher loan rate? Why help the rich get richer?
The answer is simple economics, along with some greed to attract more wealthy clients.
"The rates on jumbo loans are a symptom of the overall credit markets," says Bennie Waller, a professor of finance and real estate at Longwood University in Farmville, VA. "Lenders are very conservative in the lower- and middle-priced home markets. Such borrowers need a high credit score and an above average amount of capital. That is, lenders are focusing on the most highly qualified borrowers."
In other words, the loans offer banks low risk and high return.
How jumbo loans work
Jumbo loans traditionally have higher interest rates than conforming loans, and are meant to help highly qualified borrowers afford expensive homes. Jumbo loans are for more than $417,000 -- or $625,500 in Hawaii and Alaska -- the limits set by Fannie Mae and Freddie Mac as conforming loan limits.
To qualify for such high loans, jumbo loan borrowers are often required to have lower debt-to-income ratios, higher credit scores of 700 or better, larger down payments of at least 20 percent, and higher reserve funds than conforming loan borrowers.
Jumbo loans aren't sold to Fannie Mae or Freddie Mac, so banks have more flexibility to down payment and debt-to-income ratios, says Travis Saling, a mortgage loan officer at Sierra Pacific Mortgage in San Diego, CA. Fannie and Freddie charge specific fees called "guarantee fees" to help guard against defaulted loan exposure. Jumbo loans are cheaper, in part, because they don't have such fees, Saling says.
Go where the money is
By making jumbo loans appealing to high-wealth customers, banks can use the loans as an opportunity to cross sell auto loans, credit cards, home improvement loans, lines of credit, checking accounts and other bank services, says Norman Koenigsberg, president of First Choice Loan Services, Inc., in East Brunswick, N.J.
"It creates a client for life relationship," Koenigsberg says. "It's been a strategy for many, many years."
More affluent customers will likely have more equity in their property, partly because jumbo loans require down payments of at least 20 percent, and the home will be a better piece of collateral for the bank to have, he says.
"This has allowed the larger lenders to reach an audience that would have been harder to reach without this," Koenigsberg says.
Some lenders give a 0.25 percentage point jumbo loan discount to borrowers who open a checking or savings account with them and sign up for automatic mortgage payment, says Van Tran, vice president of The Federal Savings Bank in Chicago and owner of My VA Rates, a website that helps veterans get VA jumbo loans.
"If you have a mortgage with them and they can see all your assets, then they're going to call you from time to time and try to sell you services," Tran says of banks going after clients who are worth millions.
Investors seeking mortgages
Another reason jumbo loans are cheap is because investors want them and there isn't much supply, says Casey Fleming, president of the Silicon Valley chapter of the California Association of Mortgage Professionals. Historically the spread between conventional conforming loans and non-conforming jumbo loans is 0.50 to 1 percentage points, though on many days in today's market there's no difference at all, Fleming says.
Almost all mortgage loans are packaged into pools and sold to investors, he says. "The investors then replenish their cash by raising money, usually by issuing debt in the form of bonds, secured by the cash flow from the mortgages in the pool," Fleming says.
But worldwide unrest and financial uncertainty is increasing demand for U.S. bonds, but supply is down, he says. New mortgage originations are at a 20-year low, and competition among bond buyers and low supply drive the price up and the interest rate down, Fleming says.
Jumbo mortgage rates should go up within the next five years, Koenigsberg says, which could cause potential harm to banks holding such loans for 30 years that are collecting historically low interest rates.
Lastly, jumbo rates are low because banks are offering very low yields on their customers' deposits, often less than 1 percent on a savings account, Saling says. Having a borrower pay around 4 percent interest on a jumbo loan for 30 years leads to healthy returns that banks want to keep on their books instead of selling them on the secondary market, he says.
"Smaller companies that don't have the luxury to hold the loans are having no issues selling them as the big banks are eager to take on these clients," Saling says. "The underwriting standards are still very tight so the banks see these clients who are able to obtain jumbo loans as extremely safe investments."