If you're planning on purchasing a new home, financing is one of the most important things you need to consider. It's not just about the lender you choose, but also what type of loan you use. For higher-priced homes, this usually means getting a jumbo loan.
Jumbo loans are mortgages that fall above conforming loan limits and typically have higher qualification standards. These loans are not backed by Fannie Mae and Freddie Mac so they’re considered more of a risk to a lender. If you are considering this type of mortgage, it's important to know what your lender will review before approving your loan. That includes debt-to-income (DTI) and loan-to-value (LTV) ratios.
Who qualifies for a jumbo mortgage?
In the United States, most mortgages are purchased by Freddie Mac and Fannie Mae. These government sponsored enterprises (GSEs) buy loans from lenders and, in turn, sell them to investors. This helps reduce the risk to lenders and allows them to offer affordable lending to people across the country.
Unlike most conforming sized loans, jumbo mortgages are not purchased by the GSEs. This means the lender takes on a bigger risk. To offset that risk, lenders typically require higher standards from borrowers. In order to qualify for a jumbo loan, you may need:
- Higher minimum credit score
- Higher cash reserves
- Lower debt-to-income ratio
- Lower loan-to-value ratio
What is loan-to-value?
Loan-to-value, or LTV for short, refers to the amount of your loan compared to the lesser of the purchase price or appraised value of a home. When you purchase a home, it’s used as collateral. If you default on your loan, the bank keeps the house and sells it to recoup some of their loss. Because of this, your lender wants to make sure the house you plan to purchase is worth more than the amount they’re going to loan you.
A bank determines the value of your home through an appraisal. When you apply for a mortgage, the bank will obtain an appraisal that will look at the size of your home, your lot, the home's condition and comparable listings in the area. When it comes to jumbo loans, lenders sometimes request two appraisals. This protects the lender, but it also helps ensure you don't pay too much for your home.
How does a lender calculate LTV?
When a lender calculates LTV, they look at the amount you plan to finance versus the appraised value or purchase price of the home, whichever is lower. LTV is the amount of the loan divided by the value of the home and converted to a percentage to show the ratio.
For example, let's say you want to purchase a home for $750,000. You plan to put 25% down ($187,500) which means the loan amount you need is $562,500. The appraisal confirms the value of the house is $730,000. When you compare the loan to your home's value ($562,500 ÷ $730,000), the LTV is 77%.
A combined loan-to-value ratio, or CLTV, is used when you want to take out a second mortgage on your home. The lender will now look at the combined total of all of your loans to be secured against the subject property compared to the value. The formula is the same, except you begin with the combined total of all loans. So, in this case, it would be (Loan 1 + Loan 2) ÷ value.
Remember, jumbo loans are a bigger risk to lenders because they are not sold to Freddie Mac or Fannie Mae so your lender will expect a lower LTV than if you were using a conventional loan. The more you can put down, the better your LTV will be.
What is debt-to-income?
A debt-to-income ratio (DTI) is just as it sounds — your total monthly housing and debt payments versus your gross monthly pre-tax income. Besides LTV, DTI is one of the most important aspects a lender will look at before they approve you for a loan. Why? Because the lender wants to make sure you have the ability to repay for your loan.
If you're applying for a loan with your spouse or someone else, you may be able to use the combined income for both borrowers. However, this also means you need to include the debt of both individuals. If one of the borrowers has a high amount of debt and a comparatively low income, you may want to consider whether it makes sense for both people to be on the loan. Community property states may be different.
How to calculate DTI
The first step to calculate DTI is to add up all your monthly bills. Your lender will verify this information through your credit report and any other debts where you provide information. If you’re submitting a joint application, be sure to include outstanding debt for both of you. Next, figure out your gross monthly income. If you have more than one source of income you may be able to include it all. Things that may be considered income for the mortgage include:
- Wages (including tips, overtime and bonuses)
- Self-employment income
- Social Security
- Retirement income
- Rental income
- Child support or alimony
To calculate your debt-to-income ratio, simply add up all of your monthly debt, divide it by your monthly income before taxes and convert it to a percentage. Like with LTV, jumbo loans have higher requirements. This means you want to keep your DTI as low as possible.
Debts considered for DTI include:
- Housing payments (i.e. mortgage payment, taxes, insurance
- Other Mortgage payments
- Personal loan payments
- Credit cards payments
- Car payments
- Student loan payments
- Monthly child support or alimony
- Any other loan payments
Debts you can exclude from DTI include:
- Car insurance
- Cell phone payments
- Monthly health insurance premiums
Simple ways to improve your DTI
A high DTI can prevent you from qualifying for a home loan. This is why it's a good idea to start working on improving it before you apply for a loan. While DTI is one of the biggest considerations, it's also one of the easiest things to fix. Things you can do to improve your debt-to-income ratio for jumbo loans include:
- Pay down your bills. Instead of buying that coffee or a gym membership, consider using this money to pay down some of your larger bills.
- Call your creditor. Remember, DTI looks at your monthly payments, not your total loan balance. This means your interest rate plays a big role. Call your creditor and see if they will lower your interest rate. The answer may surprise you.
- Refinance your loans. Are you paying too much on your personal loan or car loan? Have you looked into refinancing? Depending on your current rate, refinancing your loan can save you a substantial amount of money every month.
- Choose income-based payments. Student loans can have a big impact on your finances. Income-based payments adjust your monthly loan payment based on how much you actually make. This can save you hundreds of dollars per month.
Reevaluate your needs. If you sell some things around the house, can you make enough money to pay off one of your credit cards? Get creative. It's always a good idea to work on lowering your DTI. However, be cautious about making any big changes after you apply for your loan. You can continue to pay down your debt, but don't open any new cards or do a debt consolidation after you speak to your lender. Any major changes in your credit, even if your intentions are good, can affect your ability to get financing.
What numbers are lenders looking for?
At the end of the day, your DTI and LTV are two key factors your lender will consider. A great LTV does not outweigh a lower credit score, or vice versa. And a maximum DTI for jumbo loans varies by lender. The best thing you can do is begin working on your credit and saving as soon as you know you want to purchase a home.
If you’ve used a conventional loan in the past and now need a jumbo loan, it's a good idea to talk to a Home Lending Advisor. Jumbo loans have different requirements, and it's important to know what you're getting into. Most importantly, choose a lender you can trust. Take the time to find the lender that's right for you.