Mortgage lenders are a diligent bunch. Anyone who’s taken out a home loan can probably attest to that, what with all the extensive validation requirements built into the mortgage process.
Above all else, lenders want to be absolutely certain that you’ll be able to pay back your home loan. But not all mortgages require such rigorous checks into personal finances. Referred to as "non-qualified mortgages" or non-QM loans, they’re somewhat of a contentious topic in the lending world, and not every lender is a non-QM lender.
Should non-QM loans be on your mind? To answer that question, first you need to know how non-qualified mortgages work, including the risks they present, who qualifies for them and how they affect mortgage rates.
What is a non-qualified mortgage?
Depending on the type of mortgage you're interested in and the specific loan terms you're looking for, a non-qualified mortgage may be a good fit for you.
Non-QM Loan Definition
A non-qualified mortgage — or non-QM — is a home loan that is not required to meet agency-standard documentation requirements as outlined by the Consumer Financial Protection Bureau (CFPB).
Non-QM loans may encapsulate a wide variety of mortgages, including:
- Home loans exceeding 30-year terms
- Home loans with negative amortization
- Home loans with interest-only payments
Non-QM loans may also exceed the CFPB’s current price-based thresholds:
- QM Safe Harbor APR ≤ APOR + 1.50%
- QM Rebuttable Presumption: APR > APOR + 1.50%, but ≤ 2.25%
Avoiding those agency-standard documentation requirements means lenders do not need to make a good faith determination on the borrower’s ability to repay a non-QM loan. In this case, “good faith determination” usually refers to checking W2 forms, pay stubs, bank statements and other documents that verify you make enough money to eventually pay back your home loan.
If you’re thinking that sounds pretty risky, then you would be absolutely right. Homebuyers who use non-qualified mortgages are not protected by the CFPB. But, because non-QM loans are not burdened by those CFPB rules, lenders are able to offer more flexible income requirements while setting higherinterest ratesto offset the added risk.
A brief history of non-qualified mortgages
Non-QM Loans Before the Great Recession
To really understand non-QM loans, first we’re going to need to go over a quick history lesson. Prior to the Great Recession, mortgage lenders had far more flexibility to extend home loans to people with less desirable qualifications — think low credit scores, high levels of debt and sometimes even nonexistent income. In return for approving mortgages for these folks, lenders would attach higher interest rates to their loans.
Lenders would then rate loan applicants on their perceived ability to repay the full loan amount. A better rating meant a greater likelihood for repayment, which in turn, meant less risk for the lender. Borrowers with strong credit scores, manageable debt and reliable income received “prime” mortgages.
Homeowners who didn’t meet that criteria — and, as such, were at a higher risk for default — were extended “subprime” mortgages. The catch? Subprime loans had higher interest rates, so lenders could increase profit while also extending loans to a wider range of potential homeowners.
Subprime borrowers often found they couldn’t afford to keep up with their monthly mortgage payments, resulting in defaults and foreclosures. While subprime loans were by no means the primary cause of the 2008 housing crisis, they certainly played a noteworthy role.
Non-QM Loans After the 2008 Housing Crisis
In the aftermath of that crisis, Congress enacted sweeping changes to a wide variety of industries that played a role in that financial crisis, including mortgage lending. In particular, the Frank-Dodd Act led to the creation of the CFPB. The CFPB, in turn, established rules to prevent consumers from taking out mortgages they can’t afford.
Chief among those guidelines: the Ability-to-Repay/Qualified Mortgage Rule (ATR/QM Rule), which states that lenders must make a “good faith determination” about a borrower’s ability to repay a loan before extending a residential mortgage. That includes checking bank statements, employment status, revolving debt and much more.
This rule essentially divides home loans into two broad categories: qualified mortgages and non-qualified mortgages.
Non-QM Mortgages: How Do They Work?
In some ways, non-QM loans are the new subprime mortgage, just with a new name. Lenders that offer non-qualified mortgages aren’t responsible for verifying income, reviewing existing debt and conducting other probing financial checks. Although that sounds bad — and to be sure, many people would be better served with a qualified mortgage — there are some cases where it may make sense to take out a non-QM loan for a home purchase.
Self-employed professionals, for instance, may have a difficult time meeting lender requirements around income documentation. If your income fluctuates pretty significantly from month to month, you may run into more resistance when trying to secure financing on a new home. Because non-QM loans come with more flexible financial verification processes, it may be easier to get a mortgage going this route.
Many lenders have steered away from subprime and non-qualified mortgages, but you can still find some financial institutions that offer non-QM loans on residential purchases. You should expect to pay a significantly higher interest rate on these types of mortgages compared with other types of home loans.
Also be aware that you won’t enjoy the same level of regulatory protection that qualified mortgages offer. If you default on a non-QM loan, you can’t just turn around and claim your lender took advantage of your financial situation.
Keep in mind that non-QM loans are not backed by the government to any degree. So, if you go this route, you can forget about securing a mortgage supported by the FHA, VA, Freddie Mac or Fannie Mae.
Qualified vs. Non-Qualified Mortgages
Qualified mortgage | Non-qualified mortgage | |
Lenders must follow ATR rules | Lenders do not need to follow ATR rules | |
Lenders require thorough income documentation | Lenders may not verify income | |
Borrowers must meet lenders’ credit score thresholds to qualify for a loan | Lenders may extend mortgages to individuals with low or no credit | |
QM loans may be backed by government loan programs like VA loans and FHA loans | Not eligible for VA, FHA and other government loan programs | |
Interest rates conform to current industry standards | Interest rates are often much higher compared with conventional mortgages |
Pros and Cons of Non-QM Loans
Non-qualified mortgages present a case of high risk/high reward for borrowers. If you can meet your lender’s loan eligibility requirements, you probably shouldn’t roll the dice on a non-QM loan.
For people who, for various reasons, may not fit the profile of a typical borrower, a non-qualified mortgage could present a viable path to homeownership. In either case, carefully consider the pros and cons before making a decision:
Pros
- Flexible loan eligibility requirements, including credit scores and debt-to-income (DTI) ratios
- Lenient application review processes, such as financial documentation and employment verification
- Alternative financing options for people who do not generate consistent income (contract workers, freelancers, small business owners, etc.)
- Additional loan options including extended loan terms exceeding 30 years, interest-only payments and negative amortization
Cons
- Higher interest rates, which will lead to more expensive mortgage payments
- Greater risk of default since the lender conducts a less thorough review of your finances
- Not eligible for government loan programs likeFHA loans
- Not as widely available as QM loans since fewer lenders offer non-qualified mortgages
Qualifying for Non-QM Mortgages
A better question might be who doesn’t qualify for a non-QM loan? The purpose of non-qualified mortgages is to provide people who wouldn’t normally meet standard lending requirements a way to secure financing on a new home. That being said, however, borrowers who are attracted to non-QM loans usually fall into a few different camps.
Non-QM Mortgages: Who Benefits?
- People who are unable to provide sufficient documentation regarding their finances and employment history. In many cases, these individuals are self-employed or work in fields that, by their nature, do not produce a steady financial paper trail for lenders to review. For instance, musicians, artists and contractors may struggle to create that documentation under normal circ*mstances.
- People with poor credit history. Lenders take a hard look at your credit score when deciding if they should extend financing and what interest rate to attach to the loan. If you fall below a lender’s credit threshold, a non-QM loan can seem to be an appealing alternative.
- People with high debt. Lenders typically refuse to give mortgages to anyone with a DTI higher than 50%. Digging out of that much debt can take years, which may just delay homeownership dreams even further. A non-qualified mortgage could allow folks in these conditions to buy a house while getting debt under control.
Non-QM Mortgages Over the Years
Although non-qualified mortgages are a pretty recent development, there have been some significant non-QM trends that prospective homebuyers should take into account. Most notably, during the height of the COVID-19 pandemic, non-QM activity took a huge hit.
Given the state of the economy at that time and the uncertainty surrounding the future of the job market, it’s not surprising that lenders became more risk-averse. But even lenders offering non-QM loans became more judicious about the applicant credentials they would accept.
As a result, non-QM loans were a bit more difficult to come by in 2020. Those trends have begun to revert, though, as the economy rebounds and communities reopen.
How can I apply for a non-QM loan?
Non-qualified mortgages are home loans that do not meet lending rules outlined by the CFPB. In particular, non-QM loans allow lenders to document a borrower’s ability to repay the loan using alternative methods that would otherwise not be acceptable. That means a far less rigorous application review process — in some cases, you may not even need to show proof of employment or income to qualify for a non-QM loan.
There are some clear tradeoffs to consider, though. For one, you may be at a higher risk of defaulting on these loans because you can’t be entirely sure you can afford your mortgage. Also, lenders will offset that risk by setting a higher interest rate on your home loan.
The truth is most gainfully employed borrowers should stick with conventional mortgages rather than take the chance on a non-QM loan. There’s really nothing to be gained if you already meet your lender’s qualifications for, say, a 30-year fixed rate mortgage.
Non-QM loans make much more sense if your financial or employment circ*mstances preclude you from qualifying for a traditional home loan. If you want to start on the process for a non-QM loan, please contact a loan officer to get more information on how to apply.
