One of the causes of the mortgage meltdown of a decade ago was the overuse of non-traditional mortgages, which are referred to as non-QM loans. Essentially, a non-QM loan is one that does not meet standards set by the federal government after regulatory reforms that were passed in 2009 and 2010. Below is more information about non-QM mortgages, and how they are coming back in some ways. In fact, some estimates say that the non-traditional mortgage market will double or triple in size in 2018.
Background on Non-Traditional Loans
In 2014, the Consumer Finance Protection Bureau of CFPB adopted new rules that defined what qualified mortgages (QM) are. This gave mortgage lenders protection on loans that met standards set by the federal government. This reduced the risk with fewer mortgages ending up being delinquent or in foreclosure. Also, the CFPB began the Ability to Repay minimum standards. After the new CFPB rules were adopted, loans that did not stick to QM standards were found to be non-QM loans.
A loan that is non-QM is not necessarily a higher risk loan. It just means that loan does not follow the QM definition. Generally, non-QM loans are designed today to offset some of the risks of the past. For example, many lenders require people with non-QM loans to have more cash reserves and a higher credit score.
Some of the typical types of non-QM loans today are:
- Stated income: This type of non-QM loan does not qualify as a fully documented loan. If you are not providing a fully documented proof of income, this can be a non-QM loan. Even if you have very good credit, employment history and assets, you still may have to have a non-QM stated income loan.
- Interest only: These loans were very popular in the past, but today they are not QM loans
- Higher debt to income ratios: Jumbo loans that are more than 43% DTI are usually non-QM loans. However, some loans with higher DTI that are backed by FHA, Fannie Mae or Freddie Mac may qualify as QM loans.
- 40-year loan term: A loan that is more than 30 years is a non-QM loan.
Why Non-QM Loans and Non-Traditional Mortgages Are Coming Back
As noted above, QM loans cannot have some of the features that were common 10 years ago. For instance, a QM cannot have a loan term that is more than 30 years. As some home markets are getting more expensive, millions of middle class people cannot afford a 30-year mortgage. For example, San Francisco has average home prices well above $500,000. Unless you earn a high income, it is very difficult to afford such an expensive mortgage.
So, lenders that want to get more buyers in expensive markets are offering more non-QM loans with financing up to 40 or even 50 years. These lenders must take on the higher risk of underwriting such loans. Typically, the borrower must come up with a higher down payment and have a top credit score.
Another type of mortgage that is becoming more popular is the option adjustable rate mortgage. This allows the borrower to have negative amortization for a short period. This type of ARM is not legal under the QM standard today. Lenders who want to attract more of these borrowers are offering these higher-risk loans. This type of mortgage can be attractive for a borrower in an expensive area who wants to keep the initial payment as low as possible. But regulations require the borrower to begin to pay principal after an abbreviated period.
Stated income loans are becoming more popular again as so many people earn income from non-traditional sources. Seasonal workers often get paid a lot of their income in only a few months, so these workers are increasingly turned to stated income loans.
Interest only loans are becoming popular again for the borrower with irregular income. Many such borrowers are business owners or get most of their pay from bonuses or commissions. An interest only borrower can pay only interest on their loan at first and make a bigger payment with principal later. For example, a sales agent who receives a quarterly bonus may want an interest only loan and make smaller payments for three months, and then make a bigger one when the bonus is paid.
Note that even if you get a non-QM loan, you will generally still need to provide some proof of your income. If you do not have pay stubs, you will need to provide tax returns and bank statements. The days of having no income documentation at all are mostly over.
Non-QM loans are becoming easier to get as the fiscal crisis recedes in the rear-view mirror. Also, know that you can qualify for a FHA home loan if your debt to income ratio is higher than normal. This is a qualified mortgage loan and comes with a low interest rate. It can be a great option.
Is the Non-Qualified Mortgage the Same as a Subprime Loan?
The subprime loan boom of a decade ago was quite different from what non-prime loans are in 2018. Subprime mortgages today are simply mortgages that do not fit into the traditional qualified mortgage box. These loans cannot be sold or guaranteed by Fannie Mae or Freddie Mac.
Some experts have worried that the greater number of nonqualified (QM) loans could bring another financial crisis. But generally, this fear is unwarranted because non-qualified mortgages are not the same as the old subprime loans as income and other critical information must be verified by the lender with third party documentation.
Morningstar points out that non-QM loans do not have the same characteristics of those loans of 10-15 years ago. The QM loan designation that is used by the CPFB does not always guarantee that a borrower will have strong credit and repay; neither does a non-QM loan mean that a borrower is a higher risk. There are still bad-credit mortgage programs available when the borrower can demonstrate compensating factors that can be verified by the underwriter. This doesn’t mean you will need a hard-money loan for poor credit either.
Subprime loans were high risk mortgage loans because there frequently was no verification of income. One of the most popular subprime loans was the no doc and no-income verification mortgage. The borrower would simply state on the application what their income was, and the mortgage company generally did not verify it. This practice led to millions of mortgages being taken out with no verification of the ability to repay, which caused millions of foreclosures and the entire US economy was under threat of collapse.
Today, both QM and non-QM loans issued by lenders must be proven that the borrower has the ability to repay the loan. The Ability to Repay rule was implemented in 2014. It requires that the lender make a good faith effort to ensure that the borrower has the income and assets they claim to have. This must be verified with third party documentation, including tax returns, bank statements, W-2s and pay stubs. For self-employed borrowers, a profit and loss statement is also required.
This requirement is standard for both QM and non-QM loans. It is essentially impossible today to have a stated income loan in the US with no documentation. Today’s subprime loans, even if they are non-QM, have less chance of fraud than earlier subprime loans. Major aspects of the ability to repay provision are:
- The current income and assets of each borrower
- Current employment status. QM borrowers must be employed; non-QM borrowers can have income from self-employment or investments
- Monthly payment on the mortgage loan and all other obligations
- Current debt obligations and any child support and alimony
- Credit history and DTI
All of these factors must be documented and fully considered for anyone who gets a mortgage loan of any kind.
More Information About Non-QM Loans
So, if a non-QM loan is not a subprime loan, what is it? To understand this, it is necessary to understand what a QM loan is according to the CFPB. It is a loan with the following characteristics:
- No excessive fees or points. The points and fees charged on a QM loan cannot be more than 3% of what was borrowed.
- No toxic loan attributes, such as interest only, negative amortization, no terms more than 30 years, and no balloon loans
- Limits on DTI. The rule for a QM is generally 43%, but in some cases, it can be higher if there are compensating factors, such as more down payment and cash reserves
A good example of a non-QM loan today is the interest only loan that is offered by some mortgage lenders. These loans are generally offered to higher income borrowers. Other possibilities for non-QM loans include:
- Alt-QM asset: The borrower does not have regular income, but has sufficient investments and liquid cash to make mortgage payments
- Assets must be fully documented to cover the amount of the loan with five years of reserves to cover all documented monthly expenses
- Assets may be stocks, bonds, IRAs, cash, 401ks, etc
- 12 months of bank and investment account statements are required for verification purposes
- Tax returns are not required for non-QM loans
- Alt-QM income: This non-QM loan is for the borrower who is self-employed. It requires you to have at least two years of steady employment history. Also, for this type of loan, the qualifying income is based upon 12 months of bank statements instead of tax returns
The bottom line is the old way of doing mortgage loans from 10 or more years ago are behind us. Although there are ways to get non-QM loans that do not fit into the QM box set up by the CFPB, borrowers must still show they have the employment, income and/or assets to afford the loan. Subprime loans that do not require any income verification will never come back, and this is a good thing for the US and world economy, as well as lenders and borrowers.
What is the Qualified Mortgage Rule?
It’s no secret that one of the main reason last fiscal crisis erupted was because millions of mortgages being handed out that were not carefully underwritten. Many borrowers had no hope of repaying them, and millions of home loans went into default. This crisis was the second biggest recession in the last century, and the US economy took a heavy blow.
In the wake of the ‘mortgage meltdown’, Congress and several federal agencies established the Qualified Mortgage (QM) rule as well as the Ability to Repay rule, both of which became effective on Jan. 10, 2014. Below is more information about the qualified mortgage rule and the ability to repay rule.
The Ability to Repay Rule Is Critical
This rule requires that the mortgage lender make a reasonable effort to ensure that the consumer has a reasonable ability to repay a loan according to the stated terms. The creditor is required to follow underwriting requirements that verify the borrowers’ financial information and uses third party records. The rule is relevant to all residential mortgages and includes refinances, purchase loans, home equity loans, first and subordinate liens. Thus, the mortgage company must verify the ability of the borrower to repay the mortgage loan.
Under the ability to repay rule, the mortgage company must consider the following factors:
- Current income and assets: The company must look at the assets and income the borrower has and will have in the near future. The creditor is not allowed to consider the value of the property, as well as any equity in the property. The income and assets of the joint applicant also count.
- Employment status: The lender must consider your current employment, which should ensure you have the financial ability to repay the loan. If you intend to pay the loan with your investment income, employment does not matter.
- Monthly payments: The creditor has to look at the full monthly payment for the property, including mortgage insurance, principal, interest, homeowner’s insurance and property taxes.
- Current debt obligations: The mortgage company must consider all debts that the person owes, including all credit card, car and other loans.
- Debt to income ratio: The DTI will vary based upon the type of loan being considered, but the lender must verify what the front and back end DTI is.
- Credit score: The creditor must review the credit history of each person on the loan. The credit score required to get a loan can depend upon the type of program being considered and the interest rate offered. See the minimum credit score for a mortgage loan
The ability to repay rule requires the lender to use third party documents to make the good faith determination of the ability to repay the loan. The rule mandates the lender keep evidence of ability to repay for three years.
Does the Qualified Mortgage Rule Matter?
The Dodd Frank Act states that qualified mortgages may be presumed that the lender making the loan has satisfied ability to repay standards noted above. The rule states that loans that have met the above criteria are qualified mortgages and that the creditor made an effort in good faith to determine the ability to repay.
Essential components of a QM are:
- Term of the loan is 30 years or less: No 40-year mortgages are allowed.
- Total points on the loan cannot be more than 3% of the mortgage amount
- Monthly payment on the loan must be determined by the highest expected payment in the first 60 months.
- Consider the borrower’s current income and reasonably expected income, including debt, alimony and child support.
- Debt to income ratio should not be more than 43%. However, this rule can be waived if there are compensating factors in the application, such as high credit score, cash reserves, etc.
If all of these criteria are met, and the loan has been underwritten with good faith and reliance on income verification with third party documents, then the loan is considered a qualified mortgage.
It is very important for lenders to comply with the ability to repay provision. When the creditor does not act in a proper manner, the CFPB can send out a cease and desist order or impose civil penalties on the lender. The borrower under the ability to repay rule can seek damages, statutory damages, costs and attorney fees. So, if the creditor fails to assess your ability to repay a loan, borrowers could end up with a free loan.
Thus, it is extremely critical that lenders verify the ability to repay of all borrowers. The chance of heavy financial penalties and damages means that lenders are extremely meticulous in covering their bases on verifying income from borrowers. The rules have made some loans take longer, but generally, this is regarded as a positive. If borrowers have proven with documentation that they have the ability to repay a loan, this is good for all parties involved.