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Financial Literacy

Financial Literacy

Home Financial Literacy Mortgages Conforming Loans (Fannie Mae/Freddie Mac)

Conforming Loans (Fannie Mae/Freddie Mac)

Just like shopping for clothes at department store, when you buy a shirt off the rack, it is much cheaper than having your tailor (or money-grubbing Nana) make one for you. Loans work the same way. When you have a “conforming” loan, it means that it has followed guidelines followed by the bean counters in the government in the same way The Gap sets prices for an XXX large.

The key components are loan to value ratio, debt to income level, and size of loan. There are also documentation requirements (lots of paperwork). If you live in CA, the rules are somewhat different than in North Dakota, but the lion’s share of real estate under conforming loans are in “cheaper states” where they comprise a much larger value of the house. In a high cost area, a single family, conforming loan can be for as much as $625,500, whereas in other areas of the country it is $417,000. Believe us, Dear Shmoopers - that $200,000 gap doesn’t nearly cover the price levels in California.

If you are buying a big fat home, you probably need a big fat loan. Conforming government loans will only take you so far. Beyond that, you need what is called a “jumbo” loan. Not to be confused with a “dumbo” loan, which allows you to pay it back in peanuts.

Most people view the maximum mortgage they can take out as roughly $1.1 million. Beyond that amount, the interest paid on the principal is no longer deductible on your taxes. Consequently, amounts borrowed over $1.1 million are considered twice the price (if you are in the 50% tax bracket).

The net of it is that it is bigger than the conforming guidelines and costs more. In theory, you can afford it.

Fannie Mae and Freddie Mac buy only conforming loans and then sell them in the secondary market. Fannie Mae is the Federal National Mortgage Association. It was created after the Great Depression.

Freddie Mac is the Federal Home Loan Mortgage Corporation. Freddie historically bought mortgages in the secondary market, put them all together, and then sold them to investors.

They were established to make buying a home easier and realize the dream well described by David Halberstam in The Fifties The government backs the loans with a form of guarantee and it ascribes rules to the trading and maintenance of those loans. When can they be paid off? Are there penalties to paying them off early? What happens if someone goes bankrupt? What liabilities accrue to the bank? What will the government subsidize? The rules are complex and beyond the scope of Shmoop, but basically Fannie and Freddie function to make buying a house cheaper and easier.

By buying mortgages and securitizing (selling them) in the secondary market, Fannie and Freddie historically created liquidity for banks, which could then lend more. In addition, they guaranteed the loans would get paid back. In a nutshell, Fannie and Freddie provided security, liquidity, and flexibility. The party didn’t last forever though. Eventually, their parents came home and put an end to all the fun.

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