What is luxury home financing?
There are luxury home financing products available in the United States that are used to entitle borrowers to mortgages on properties without conforming to traditional mortgage guidelines (1) and cannot be delivered or negotiated with institutions like Fannie Mae (5) due to the fact that the loan amount exceeds the legal limits for conforming loans (2). For the vast majority of counties in the United States with some exceptions in non-contiguous states (7), the maximum conforming loan amount is $548,250 after the Federal Housing Finance Agency (FHFA) (3). There are jumbo loans available for those loans that exceed the local conforming loan limit and those are considered non conforming loans (4) (6).
Luxury home financing is a type of mortgage loan that exceeds the loan 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 come with unique underwriting requirements and tax implications.
In the event that you would like to purchase a home that costs nearly half a million dollars or more and are not in a position to handle the payment through your bank account, you’ll probably need to take out a jumbo loan to secure luxury home financing. There is a strong likelihood that you will have a much more difficult time obtaining one than you will if you apply for a conventional loan or an FHA loan. There is no guarantee from Fannie Mae or Freddie Mac when financing a luxury home. Because of this, lenders are more inclined to take on more risk when financing a luxury home. Aside from the fact that the government isn’t guaranteeing these transactions, there is also the fact that the transactions are involving more money.
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.
Luxury home financing, performed through mortgage loans, exceeds the mortgage amount that Fannie Mae and Freddie Mac will purchase from lenders.
It is possible in this model to acquire a property behind the curtain of an LLC, protecting privacy and avoiding having the property in our own name. This is not possible in conforming loans, but here we are discussing a non-conforming mortgage loan.
High-net-worth home buyers are attractive to lenders because their substantial income and assets make them appear to be less of default risk. And many banks offer loans to entice premium clients.
That is why loan requirements are different than conventional loans and typical FHA loan requirements.
Loan Limits In Luxury Home Financing
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.
Also FHA loan limits are much lower than for these non-conforming loans.
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 2021, the limit was set at $496,375 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 that 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
Underwriting criteria for luxury home financing are stricter because the loans are larger and riskier for lenders.
- High credit score: Higher than 700.
- A debt-to-income ratio of at least 43%
- Down payment of about 15%
- Cash reserves to cover at least one year of payments of the loan.
- 30 days of pay stubs, W2 tax forms for the last two years and some lenders would require copies of 1099 forms issued.
- Two months of bank statements.
- Home inspections and appraisals are required as usual.
Just like traditional mortgages, minimum requirements for luxury home financing, as nonconforming mortgage loans they are, have become increasingly stringent since 2008.
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.
Many potential borrowers are famous people, including entrepreneurs, film producers, and athletes. Some of them are not focused on their day-to-day financials, resulting in less-than-stellar credit scores.
Loans without consideration of the debt-to-income ratio are the no ratio loans, and we discuss in this article, how can you apply for one. Nevertheless, this is not the situation of this type of loan we study here.
Despite the fact that luxury home financing is not a conforming mortgage loan, it must still comply with consumer protection provisions for what the CFPB finds to be a “qualified mortgage”: a lending system with standards and rules unlike traditional-home loans like a 43% debt-to-income ratio.
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%.
Down Payments For Luxury Home Financing
In the first version of this article, I was writing that lenders of mortgage loans for luxury home financing required home buyers to put up to 30% of the purchase price of the residential property (compared to 20% for conventional mortgages).
However, down payment requirements have loosened currently since 2022. Now, that figure has fallen as low as 10% to 15%.
As with any mortgage loan, because that is how luxury home financing is arranged, there can be various advantages to making a higher down payment, among them, to avoid the cost of private mortgage insurance, lenders require down payments below 20%.
Therefore, if you are interested in a lower down payment rate (lower than 20%), you could be required by your lender to become a policyholder for private mortgage insurance, an extra cost to weigh in your options.
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).
Some lenders may require a second home appraisal for the property that you are planning to purchase. But this is not common.
General regulations and due diligence are not foreign to this type of financing. So inspections in septic tanks and peeling paint are required here and should be part of the due diligence of prospective buyers.
Also, we include here checking for aluminum wiring and the remediation process required in some cases to bring it up to code through a compliant “pigtailing” or rewiring to copper.
Interest Rates For Luxury Home Financing
While luxury home financing used to carry higher interest rates than conventional mortgages, and this is still the case, the gap has been closing in recent years. Today, the average annual percentage rate (APR) for luxury home financing, performed through a jumbo mortgage loan is often par with conventional mortgages, and in some cases, actually lower.
According to lenders and underwriters that I know from my own business, the reason for these lower APRs is, as we can all imagine, to attract more borrowers for luxury homes. They explained that these borrowers are just the sorts of individuals that institutions love to sign up for long-term products, partly because they often need additional wealth management services, and they can cross-sell them other products such as investment portfolios, mortgage notes, wealth management, and private banking. Plus, it’s more practical for a bank to administer a single $2 million mortgage than 10 loans valued at $200,000 apiece.
For example, Wells Fargo charged an APR of 4.092% on a 30-year fixed-rate conforming loan and 3.793% for the same term on a non-conforming loan eligible for luxury home financing and arranged as a jumbo loan.
Even though the government-sponsored enterprises can’t handle them, jumbo loans are often securitized by other financial institutions; since these securities carry more risk, they trade at a yield premium to conventional securitized mortgages. However, in reality, this spread has been reduced with the interest rate of the loans themselves.
Tax Deductions Available
Just because you may qualify for one of these mortgage loans utilized for luxury home financing, doesn’t mean you should take one out. You certainly shouldn’t if you are counting on it furnishing you with a substantial tax break, for example.
You’re probably aware that you can deduct the mortgage interest you paid for any given year from your taxes, providing you itemize your deductions. But you probably never had to worry about the cap the IRS places on this deduction—a cap that was lowered by the passage of the Tax Cuts and Jobs Act. Anyone who got a mortgage on Dec. 14, 2017, or earlier can deduct interest on up to $1 million in debt, which is the amount of the old cap.
But for home purchases made after Dec. 14, 2017, you can only deduct the interest on up to $750,000 in mortgage debt. If your mortgage is larger, you don’t get the full deduction. If you plan to take out a $2 million mortgage loan that accrues $80,000 in interest a year, for example, you can only deduct $30,000—the interest on the first $750,000 of your mortgage. In effect, you only get a tax break on 37.5% of the mortgage interest.
That means you should borrow with care and crunch the numbers carefully to see what you can truly afford and what kinds of tax benefits you will receive. With the state and local tax deduction limited to $10,000 a year, due to the same tax bill, a highly taxed property will also cost you more to own.
One other strategy: Compare terms to see if taking out a smaller conforming loan, plus a second loan, instead of one big mortgage loan. It might prove better for your finances in the long haul.
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 these type of loans from conforming loans we have:
Privacy And Asset Protection
It is possible to pay a premium to protect privacy by closing a sale through a limited liability company (LLC), which is prohibited for Freddie Mac and Fannie Mae mortgages, but absolutely possible in non-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%.
Similar interest rates
Currently, the average annual percentage rate (APR) for luxury home financing, is frequently the same as with conventional mortgages, or just slightly higher.
APRs here are moving in the range of 3.6 to 4.1 %, very similar to the APRs of conforming loans.
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 rates (we refer here to APRs) that are competitive with rates on conforming loans.
Furthermore, some may even offer slightly lower rates depending on market conditions, so make sure to shop around and request several quotes.
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 and the participants do not have to care about factors as notices to homeowners or identity of interest.
But since the crisis, we’ve seen a phenomenon where these non-conforming rates are as low and sometimes lower than rates of conforming loans.
Higher closing costs and fees for luxury home financing
Because these loans are bigger and there are some extra qualifying steps, expect higher costs at the closing table too.
Loan Types in Luxury Home Financing
The legal and financial nature of these loans is a non-conforming mortgage loan, and the loan type is a so-called jumbo loan.
It is technically possible to see in the financial market other figures for these mortgage loans as non-QM mortgages provided by subprime lenders. But there are many documentation requirements for financing luxurious homes and an income history required. These requirements leave these non-QM mortgages out of the equation here.
Also, there could be financing for this kind of loan through a bank statement loan, at least technically speaking. However, bank statement loans rely heavily on the average bank statement balance, and in this type of financing we are discussing here, your bank statements are just one of the loan requirements.
This leaves the jumbo loan, which is a non-conforming mortgage loan, as the financial instrument utilized here.
Whom Is Luxury Home Financing For?
Luxury home financing, as we explained above, arranged through non-conforming mortgage loans, is considered most appropriate for a segment of high-income earners who make between $250,000 and $500,000 a year.
This segment is known as HENRY, an acronym for “high earners, not rich yet”. Basically, these are people who generally make a lot of money but don’t have millions in extra cash or other assets accumulated, yet.
While an individual in the HENRY segment may not have amassed the wealth to purchase an expensive new home with cash, such high-income individuals do usually have better credit scores and more extensively established credit histories than the average homebuyer seeking a conventional mortgage loan for a lower amount.
They also tend to have more solidly established retirement accounts. They often have been contributing for a longer period of time than lower-income earners.
How much you can ultimately borrow depends, of course, on your assets, your credit score, and the value of the property you’re interested in buying.