Jumbo Mortgage Loan : May 2008

Most homeowners want to get their house paid off as quickly as possible. It's in our American psyche. Not having to make a large payment, and not having to worry about losing your house because you don't have a loan are huge emotional benefits.

I understand these emotional benefits. However, I think many people make the mistake of isolating the payoff of the mortgage as the "high and mighty" goal while downplaying other important financial objectives, not to mention the tax ramifications of paying down the mortgage.

Here is when a 15 year loan does not make sense:

- The homeowner does not feel comfortable with the mortgage payment.

- The homeowner does not have six months of savings in a purely liquid account in case of income interruption. Life happens - having six months of liquidity for emergencies is great financial protection in case of an emergency. 

- The homeowner carries credit card debt - how much sense does it make to pay principal while paying high interest on non-deductible debt?

- The homeowner is not fully funding retirement as allowed by tax laws - a homeowner is letting the IRS whack him twice by paying principal, which reduces the interest deduction, and not taking advantage of tax advantaged accounts that they could be using.

- The homeowner does not have enough funds to pay for higher education for their children - they'll probably wind up refinancing anyway to pay for it.

- The homeowner does not have adequate life, disability, and/or health insurance - Is it smart to leave a non-working spouse with a high payment 15 year loan without adequate insurance coverage?

Here is one another scenario where it does not make sense. Suppose you have enough liquidity set aside to pay the loan off. Why would you continue to pay a large chunk of principal each month and erode your tax benefits of the interest deduction?

Here is another example of why it does not make sense. I learned this listening to a podcast of a very wise, in my opinion, mortgage advisor named Ed Conarchy. He said something like this, "Suppose I gave you a dollar. Would you rather invest it in something that taxed you at your ordinary income rate (which for many of us is in the 25% to 40% range), or at the capital gains rate, which for long-term capital gains is 15%?"

 When you pay principal, you are reducing the amount of interest owed, therefore, you are decreasing your interest deduction, and increasing your taxable income. Are you better off taking that dollar and investing it in something that taxes you at a lower rate? I know my answer.

The point of this article is that the homeowner's whole financial picture needs to be evaluated, hopefully with the help of competent advisors on both the asset side and liability side of the balance sheet.

As you may be aware, Freddie Mac and Fannie Mae have temporarily raised the limits for the size of a loan (called an agency jumbo loan, or conforming jumbo loan) that they will buy to $729,750 in certain high cost areas, such as San Mateo, Santa Clara, San Francisco, and Marin Counties.

What you may not be aware of are the guidelines are different for the agency jumbo loans than they are for the traditional conforming loans.

The agency jumbo loan will allow a borrower to borrow up to 90% of the sale price. Mortgage insurance is required above 80%.

Seller contributions are allowed up to 3% of the sale price. Many times borrowers use these funds to finance a buydown of the interest rate.

Let's look at an example of a buydown scenario using today's market rates on a listing price of $800,000. With 10% down, the loan amount would be $720,000.

Let's assume you have a choice of reducing the price $24,000, or getting the seller to contribute $24,000 toward closing costs. Which choice is best for you, the home buyer?

Let's look at reducing the price first. With a $776,000 sale price, 90% of $776,000 is $698,400. The rate with no points is 6.625%, and the principal and interest would be $4472. Property taxes, using 1.25% of the sale price is $808 per month. Mortgage insurance would be $303 per month. So, the total would be $5583 per month.

Now let's assume the other scenario. The sale price will be $800,000. The seller is going to contribute $24,000 toward the closing costs. The buyer decides to use this contribution to buy down their interest rate. With a $720,000 loan amount, he will be able to obtain a fixed rate at 5.75%. The principal and interest would be $4202 per month. The property taxes would be slightly higher, $833 per month. The mortgage insurance would be slightly higher, $312 per month. The total would be $5347 per month.

I strongly believe in the buydown strategy. Although this buyer had to pay $2400 more toward his down payment, the benefits far outweigh the costs.

This buyer will save $236 per month. This savings can be used to fund something useful, such as a college or retirement fund.

Most importantly, there is a benefit most people don't realize; although the seller pays for the buydown, the buyer gets a tax benefit although the seller made the contribution for it(I am not a licensed tax preparer - please consult with your licensed tax preparer for limitations).

In this example, if the buyer was in a 33% tax bracket, he would realize an $8000 tax savings in the year he purchased ($24,000 x .33% tax bracket in points paid to buy down the rate to 5.75%)!

The buydown of a conforming jumbo loan is a great strategy for all involved.

Buyers benefit from reduced monthly payments and tax benefits.

Sellers benefit from using a unique strategy to get their house sold.

Real estate agents benefit because if they use this strategy they will be viewed to be more knowledgable than the average agent. In addition, they will gain a reputation as being able to sell homes at a higher price, because this strategy helps the values in the neighborhood.