What is a Nonconforming Mortgage?
A nonconforming mortgage is a loan for a home that does not follow government-sponsored enterprise (GSE) guidelines. GSE guidelines tend to include maximum loan amounts, downpayment requirements, credit requirements, and more. As the loans do not follow the above requirements and are more difficult to sell, they tend to be riskier; thus, they carry higher interest rates over conforming mortgages.
What is a Government-Sponsored Enterprise GSE?
A government-sponsored enterprise (GSE) is a government-held entity used to distribute credit across sectors within the United States. They help facilitate debt for all individuals. Within the U.S., the three GSEs are:
- Federal Home Loan Mortgage Corporation (Freddie Mac)
- Federal National Mortgage Association (Fannie Mae)
- Government National Mortgage Association (Ginnie Mae)
The three GSEs listed above were formed to increase the flow of debt surrounding the housing market while being cost-effective.
How Nonconforming Mortgages Work
Generally speaking, banks write the majority of mortgages, and they are often compiled in GSE portfolios by Fannie Mae and Freddie Mac. Specifically, Fannie Mae and Freddie Mac purchase the mortgage loans from banks, combine them into mortgage-backed securities and sell the loans on the secondary market.
From the sale of mortgages by GSEs, banks use the money to invest in new loans at the rate that is offered. However, it is important to recognize that Fannie Mae and Freddie Mac cannot buy any mortgage securities, as they must abide by federal rules and limits. For example, loans purchased must be relatively risk-free. Thus, the loans that meet the requirements by GSEs are known as conforming mortgages, which banks favor.
Mortgages that do not meet the GSE requirements are nonconforming loans and are unsellable to Freddie Mac and Fannie Mae; thus, they stay in a bank’s portfolio or are sold to purchasers that specialize in nonconforming mortgage loans.
Types of Nonconforming Mortgages
Various types of nonconforming mortgages do not meet Freddie Mac and Fannie Mae’s criteria:
1. Jumbo mortgage
A loan that exceeds the limit that Fannie Mae and Freddie Mac would offer. For example, the limit within the U.S. is approximately $510,000. However, in certain areas such as San Francisco or New York City, where population density is high, the limit can be as large as approximately $766,000, which exceeds Fannie Mae’s and Freddie Mac’s offering.
2. Low downpayment
If the downpayment on a mortgage is low, it can also be considered nonconforming. The threshold can vary from 3%-10%.
3. High Debt-to-Income (DTI) ratio
In order to qualify as a conforming loan, the buyer needs to demonstrate a DTI ratio that is lower than 42% and a credit score that is above 630-650. Anything higher and not within the respective range would be considered a nonconforming mortgage. For example, a buyer with a DTI of 50% and a credit score of 600 likely would only qualify for a nonconforming loan.
Benefits of Nonconforming Loans
1. Lower downpayment requirements
Relative to conforming loans, nonconforming government-backed loans usually come with lower downpayment requirements. For example, individuals can purchase a house with 0% downpayment if they qualify for nonconforming government-backed loans.
2. Larger loan limits
If individuals wish to purchase an expensive property, they can apply for a jumbo loan, which gives access to higher loan limits over conforming loans.
3. Access to more types of properties
Relative to a conforming loan, a nonconforming loan may allow individuals to purchase a property they cannot get with a conforming loan.
4. Lower credit required
In a sense, nonconforming loans target a wider audience, as they allow individuals with lower credit scores to receive a customized solution by the lender.
Downside of Nonconforming Loans
The downside of a nonconforming loan is that individuals are exposed to higher interest rates and therefore, must pay larger coupons on a fixed basis.
When to Choose a Nonconforming Loan
It may be best to choose a nonconforming loan if the following features are appealing and within one’s favor:
- 0% downpayment
- Lower credit requirements
- Higher limit
Generally, nonconforming loans are ideal for individuals who are unable to meet conforming loan requirements, yet wish to buy a home despite their lower credit score. It is once again important to be reminded that nonconforming loans tend to charge higher interest rates over a period of time.
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