Mortgage rates have risen dramatically in 2022, and this means rate-and-term refinances have all but disappeared. The Mortgage Bankers Association’s refinance index (based on weekly application volumes) plunged by 68% from April 2021 to April 2022.
With this source of business drying up, where can mortgage originators find deals? Nonqualified mortgages (non-QM) offer an often overlooked way to refill your pipeline. Non-QM loans are quality loans that fall short of the standards set to be purchased by Fannie Mae and Freddie Mac.
Each of these types of loans present opportunities for originators. Non-QM lenders are willing to finance properties and borrowers that the GSEs won’t.
Contrary to common misperceptions, non-QM borrowers aren’t risky clients. Many have stellar credit scores, plenty of assets and significant cash for downpayments. They’re good borrowers who simply don’t fit the agencies’ strict guidelines.
Despite this reality, some in the mortgage industry still believe there is only one path for well-qualified borrowers to get a loan. In truth, the non-QM channel represents another road to approval for borrowers who have strong finances but need to document their income differently to qualify for a loan.
Creditworthy borrowers
Conforming loans — those bought by Fannie and Freddie, the government-sponsored enterprises (GSEs) — dominate the mortgage market. For borrowers with stellar credit, plenty of cash for a downpayment and easily verifiable W-2 income, GSE loans are the gold standard.
Not every borrower conforms to the strict requirements imposed by Fannie and Freddie. Maybe a client is a business owner whose tax returns show only a modest income. Maybe they are a property investor, a citizen of another country, or someone looking to buy a nonwarrantable condominium or condotel. Each of these scenarios are reasons for the agencies to reject loans. If a homebuyer doesn’t fit into the agencies’ boxes, however, it doesn’t mean they aren’t creditworthy.
That’s where non-QM loans come in. Non-QM loans are a type of financing that cater to borrowers in situations that Fannie and Freddie routinely reject. Private lenders don’t sell loans to the GSEs and aren’t bound by their rules. Instead, non-QM lenders tailor commonsense guidelines that are geared toward approving strong borrowers.
Non-QM loans are a relatively new product and make up only a fraction of a mortgage market where the lion’s share of loans are backed by Fannie, Freddie, the Federal Housing Administration and the U.S. Department of Veterans Affairs. So, it’s understandable that these mortgages are not well understood. While the non-QM market is well established, widespread misconceptions and mysteries still exist.
Unlike the subprime loans of yesteryear, non-QM loans fill a need for a growing number of qualified borrowers. These borrowers are often creditworthy and well qualified, but they don’t fit the agencies’ underwriting criteria.
Make-sense niches
Non-QM lenders find niches that make sense. The experience of many non-QM lenders underscores the fact that many strong borrowers are looking for credit but aren’t eligible for GSE financing. These borrowers overwhelmingly have high credit scores, low loan-to-value ratios and plentiful assets.
But they come to non-QM lenders because their files don’t fall within the agencies’ boundaries. Non-QM encompasses a variety of specialty mortgage products, including:
- Bank-statement loans. These borrowers are often self-employed and are frequently more affluent than those with W-2 incomes, but prudent tax planning means they show a level of income on their tax statements that precludes them from agency loans.
- Property investors. These loans focus on a property’s cash flow. They are underwritten based on rental income and mortgage debt — and given the strong rent-price growth across the country, many real estate investors are doing quite well.
- Foreign nationals. Residents of other countries can’t qualify for agency loans, even if they’re wealthy and can easily repay their mortgages. These loans are underwritten based on the foreign national’s stability and ability to repay.
- Nonwarrantable condos. Fannie and Freddie impose stringent rules around mortgages collateralized by condos. GSE-backed condo loans became even more difficult to obtain after new rules implemented after last year’s condo collapse in Surfside, Florida.
- Asset qualifier and asset depletion. These loans calculate income by determining the borrower’s total assets divided by 60 or 120 months.
- Bridge financing. This is a short-term loan that taps equity in an existing home, providing cash for a new home purchase with no monthly payments on the bridge loan.
Each of these types of loans present opportunities for originators. Non-QM lenders are willing to finance properties and borrowers that the GSEs won’t.
Individualized underwriting
Compared to agency loans, non-QM loans are underwritten differently. The conventional underwriting process requires arduous documentation. A human might gather the electronic files, but the documents are then pushed through an automated process. Fannie’s system is known as Desktop Underwriter, or DU. Freddie’s is Loan Prospector, or LP.
The computers that examine the paperwork often find reasons to say no — and they reject applications based on these issues. Fannie and Freddie buy the majority of mortgages originated in the U.S. housing market, and the sheer volume dictates that an automated system is necessary.
Non-QM loans often require substantially less paperwork from mortgage applicants. Because the human processors and underwriters are aware that these files may contain unique circumstances, they are specifically looking for ways to approve the loans. That’s a sharp contrast to the agency approach as the GSEs’ automated systems look for reasons to reject loans.
Non-QM loans are less common than conforming loans, and the relative rarity of these mortgages means that the process remains shrouded in mystery for many industry players. But the underwriting process for non-QM loans is straightforward.
Depending on the type of loan, non-QM lenders focus on a variety of data points — a business owner’s bank statements or an investor’s cash flow, for instance — to determine whether a borrower qualifies for financing. The bottom line is that these borrowers are willing and able to repay, and savvy mortgage originators are learning how to do business with them. ●
