What it is:
How it works (Example):
Once a loan is made between from a bank to a home buyer, the loan is typically sold into the secondary market. The largest buyers of these loans in the secondary market are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), both government-sponsored enterprises created to provide liquidity to banks. Fannie Mae and Freddie Mac follow guidelines for loan terms set by the Office of Federal Housing Enterprise Oversight (OFHEO). The OFHEO adjusts the conforming loan sizes each year.
When a loan does not "conform" to these terms, it cannot be purchased, guaranteed, or sold by Fannie Mae or Freddie Mac. Instead, it may be sold to other secondary market buyers, including insurance companies and investment banks, in the capital markets. Since these jumbo loans carry higher risk, buyers of the loans are often compensated with higher effective interest rates (25 to 150 basis points), variable interest rates, higher down payment amount, or sometimes shorter terms (with a balloon payment due at the end).
Why it Matters:
Over time, jumbo loans were used mostly for luxury and second homes. However, with the rapid rise in real estate prices in most markets, the maximum loan amounts for conforming loans was often exceeded in the purchase of non-luxury and primary homes. This forced many homebuyers to take out jumbo loans, with higher costs and more risk of not being able to make payments.
Indeed in 2008, with the failure of the "subprimemarket and the resulting credit crisis in the banking industry, the Federal Government-directed Fannie Mae and Freddie Mac to increase their thresholds in order to include jumbo loans that can be purchased under their programs."