You've heard the term "conventional" financing, but what does this expression really mean to mortgage borrowers?
Real estate is local but financing is not. The money you borrow to finance or refinance your home likely comes from a huge pool of funds that ultimately comes from investors nationwide.
The system works like this: A local lender has $8 million and makes 80 mortgages, each for $100,000. Having loaned out all the cash it has, it might seem as though the lender is now out of business. But now, instead of cash, the lender has 80 mortgages -- assets which can be sold.
The lender sells the mortgages to such organizations as Fannie Mae and Freddie Mac. Once the loans are sold, the local lender now has more cash and can make additional loans.
The catch is that Fannie Mae and Freddie Mac don't buy every loan. They only buy loans which meet certain standards, and it is those qualifying loans which we call "conventional" financing.
For instance, a 30-year mortgage with 20 percent down made to a qualified owner occupant could be an example of a "conventional" loan. A local lender can make conventional loans and know with certainty that they can be sold.
While the length of the loan and the amount down are steady, one aspect of conventional financing changes each year: the maximum loan amount.
In 2000, for example, the conventional loan limit for a single-family home is $275,000. The limit is higher for duplex properties ($351,900), triplexes ($425,400), and four-unit homes ($528,700) where at least one unit is owner-occupied. The limit is also 50 percent higher in Alaska, Hawaii, Guam, and the U.S. Virgin Islands.
The conventional loan limit also impacts FHA financing. The maximum loan amount for an FHA loan can be no more than 87 percent of the conventional loan limit. So, if the top conventional loan amount for a single-family home is $275,000, the highest FHA loan amount will be $239,350. The maximum FHA loan amount is not available in all areas, however, so check with your broker or lender for details.
Okay, so why does the conventional loan limit matter to borrowers?
Let's say you want to buy a home for $343,750. With 20 percent down you'll need $275,000 in financing, the conventional loan limit at the moment.
But let's say you want to purchase a home for $360,000. With 20 percent down it will take financing worth $288,000 to close the transaction. The catch is this: $288,000 is above the conventional loan limit. It's a "jumbo" loan which means the interest rate will be perhaps .5 percent higher than the rate for conventional financing. In the first year, that half point may cost you $1,400.
What to do?
If possible, arrange your financing so the first loan does not cross the conventional limit. For instance, for the $360,000 home you might want to increase your cash down payment. Or, have two loans, say a $275,000 first loan, a $15,000 second, and the rest of the purchase price as a down payment in cash.
Also, check the conventional loan limit in January. The limit is raised at the beginning of each year and it could increase to the point where more cash or a second loan are unnecessary. In fact, the limit could increase enough so that even less cash is required to buy.