Most people are familiar with typical mortgages, like FHA, VA, and conventional loans, but you may not realize that there's a whole other group of mortgages called non-qualified mortgages. A non-qualified mortgage includes features not found in standard mortgages or allows borrowers who are excluded from traditional mortgage products.
Definition
What is a non-qualified mortgage?
A non-qualified mortgage is a mortgage that doesn't conform to standards set by the Consumer Financial Protection Bureau (CFPB). That doesn't mean these are bad loans, but it does mean that they may have nontraditional mortgage features or nontraditional mortgage qualification terms. They're good for people who have nontypical income, like business owners, or those who are rebuilding their credit.
Non-QM mortgages often have repayment periods that deviate from the norm or have balloon payments due at the end. It's important to understand the terms of these loans before you agree to one for any amount of time. For many people, it makes more sense to get a non-qualifying mortgage than to continue renting, since the borrower can generally refinance later when their credit is stronger.
Pros and cons
Pros and cons of a non-qualified mortgage
People often have knee-jerk reactions about non-qualified mortgages, assuming they're always scams or underwritten by bad actors. But the truth is, they can be useful for specific purposes.
Pros
- Alternative income verification methods allowed. People with self-employment income, gig economy income, or who live off investment income may have a better chance of being approved for a non-QM loan.
- Credit qualification can be more flexible. People have credit problems for all kinds of reasons, including messy divorces, unexpected and serious medical conditions, or unplanned losses of income. Most non-QM loans are manually underwritten, allowing each company to decide if these things are signs of risk, or simple one-time runs of bad luck.
- Lower initial payment. Suppose you live in a housing market with extremely high prices compared to average incomes. If you expect that your income will grow -- say, for example, you've just graduated from college -- the lower initial payment that's possible with certain types of non-QM loans may make buying a home easier. Options like interest-only loans can get you started on home ownership -- just don't forget that you almost always have to refinance these loans at some point.
Cons
- Increased risk of default. It's well-known that non-qualified mortgages are more likely to go into foreclosure because of the way they're put together. That doesn't mean you're guaranteed to run into trouble, but the risk is higher.
- Higher costs over the loan's lifetime. Because non-QM loans often carry slightly higher interest rates, borrowers end up paying more each month for their mortgage. They may also pay more at closing for the note, since non-QM mortgages aren't regulated in the same way as qualifying mortgages are.
- Unusual features. It can be easy to encounter problems with non-qualified mortgages because of unusual features that come with them, like balloon payments, interest-only payments, or pre-payment penalties. If a borrower doesn't understand the consequences of these loan features, they can create serious long-term issues.
Non-qualified vs. nonconforming
Non-qualified mortgages vs. nonconforming mortgages
Both non-qualified mortgages and nonconforming mortgages fail to meet the requirements of mortgages deemed to be traditional or typical, but they are different products. Each type of mortgage carries more risk and is meant for specific circumstances. The main difference is that non-qualified mortgages don't follow underwriting standards set by the CFPB, while nonconforming mortgages fail to meet loan purchasing guidelines set by Fannie Mae and Freddie Mac.
A non-qualifying mortgage may have unusual loan terms and allow less stringent underwriting for people with lower credit scores or inconsistent incomes, whereas nonconforming loans don't meet Fannie and Freddie's underwriting criteria -- most often by exceeding the amount for which these loans can be written. Jumbo loans are a very common nonconforming loan option, though government-backed loans like FHA, VA, and USDA mortgages are technically non-conforming loans, as well.
Related investing topcis
Why this lending matters to investors
Why non-qualified mortgage lending matters to investors
Not every investor is going to care about non-QM loans. But if you invest in mortgage-backed securities (MBS), mortgage REITs, and banks that make these loans, you should pay close attention to non-qualified mortgage loans and how they increase risk for investors. For example, if you buy MBS products that contain non-QM loans, you'll probably get offered a great rate of return, but that's because the risk of default is quite high for some percentage of the mortgages in your security. You'll then have to balance the risk with the reward, based on your own risk tolerance.
For those who invest in banks that hold mortgage notes, it's just as important to get curious about how much of their portfolio is non-QM mortgages. Again, a higher default rate means that there is more risk involved, so if two banks are equally profitable, and one has few or no non-QM loans on their books, it could make more sense to choose that bank over the one with the riskier products.
