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Fannie Mae and Freddie Mac

If you head into a tailor shop to buy a bespoke suit, you're going to pay a lot more than you would if you went to Men's Warehouse and bought one off the rack. Why? Well, the mass-produced suits are made in huge amounts by machines, so the per-suit price is low. On top of that, the store sets the prices so that you pay roughly the same lower price for the same suit, whether you're shopping in Idaho or Timbuktu.

Loans are a little like that.

Two Organizations with Weird Names

There are two government-created groups very interested in your mortgage: 

  • The Federal National Mortgage Association (cutesy nickname: Fannie Mae)
  • The Federal Home Loan Mortgage Corporation (cutesy nickname: Freddie Mac).

Fannie Mae was created during the Great Depression of the 1930s and Freddie Mac was created in the 1970s; both are still around today.

Fannie Mae and Freddie Mac are what are known as government-sponsored enterprises (GSEs) because the government was part of creating them (which is how they got stuck with nicknames that got them teased on the playground). Their job is to make sure that home loans are affordable so more Americans can buy their own house.

Both Fannie Mae and Freddie Mac buy conforming home loans and re-sell them on the secondary market. Just like your great aunt likes to buy collector's teapots and sell them in groups of three on eBay for a profit, Fannie Mae and Freddie Mac buy mortgages from banks, bundle them together, and sell them to investors so that investors can get richer.

But they only do that with conforming loans.

Conforming to What?

Conforming loans are loans that have met specific rules set out by the government. There's more than one government involved, though, so the rules of conforming loans may be slightly different in, say, California than they are in Kentucky.

To be a conforming loan, your mortgage has to toe the line when it comes to

  • loan size. In many places, the current limit for conforming loans is $417,000, so if you're borrowing $417,003 from the bank, you'll want to dig into your piggy bank to bring that number down. If you live in some areas where the cost of real estate is higher (San Fran, we're looking at you) then you might get a limit up to $625,500. Oh, and P.S. the government can decide to increase those limits if they want.
  • paperwork. Conforming loans need enough paperwork to make trees shake in fear.
  • debt to income level. If you max out your credit taking on a loan that eats a big chunk of your income, you're probably going to be living on PB & J sandwiches for a long time to afford it. Your mortgage also won't be a conforming loan.
  • loan to value ratio. Sure, you might absolutely need to buy that house with the six-foot mural of the Cowboys cheerleaders, but that huge mural likely brings down the value of the house (only because most homebuyers like to keep smaller pictures of the Cowboys cheerleaders under their mattress). The problem with buying a home with a lower value and taking out a big loan on it is that it messes up that tidy loan to value ratio. In other words: it makes bankers nervous that if you can't pay your loan, you won't be able to sell the house for enough cash to cover what you've borrowed.

If you've had your latte this morning and are feeling alert, you've probably noticed that all of these things (smaller mortgages, low debt to income and loan to value ratios) make conforming loans less of a risk for lenders. Well, take a gold star. That's exactly what they are.

And because they're less of a risk for lenders and because someone is making a profit by reselling them to investors, you get a few perks, too. Not a private jet and access to the VIP lounge like a rich investor, but still pretty good. If you get a conforming loan to pay for your house, you'll enjoy lower interest rates and better terms. You might also not need to pay even more for mortgage insurance. No confetti, but we're talking about the government, so what did you expect?

Why are Fannie Mae and Freddie Mac so interested in conforming loans? The two GSEs are supposed to make buying a home more affordable and easier. The government backs conforming loans and guarantees them, but it makes sure that there are rules—the government loves rules.

Banks love rules, too, so when Fannie Mae and Freddie Mac buy their loans and bundle them up like pigs in a blanket to re-sell as investments, they love it because it leaves banks with more cash that they can loan out and make interest on.

More Numbers to Crunch

In some markets, a $417,000 or even a $625,500 mortgage won't even get you a nice parking spot. So what happens if you aren't part of the mob and need a bigger loan? If your mortgage doesn't conform, it's what's known as a "jumbo" loan. And just like a jumbo jet, it's going to cost you more (and won't fly you to Maui).

There's another number for you to take a look at: $1.1 million. This is the upper limit for some of the nice perks you enjoy with mortgages. Once you take out a home loan over that amount, the government and your banker will assume that you're really rich…and while they'll be super nice to you, they'll give you fewer breaks. Your mortgage interest will not be tax-deductible and you'll probably need a bigger down payment. You're probably in the 50% tax bracket if you have that kind of loan, so you might like the idea of that deductible. But since you've got the cash, your XXL mortgage will basically cost you twice as much as a smaller one.

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