What is a non-QM loan? The lowdown on non-qualifying mortgages

Some homebuyers don’t fall into the standard mortgage lending box. Usually, it’s for factors related to their creditworthiness and income level or income predictability. That’s where a non-qualified mortgage — non-QM for short — can fill the gap. While non-QM loans offer more lenient credit and income requirements, they also come with higher down payments and interest rates — and sometimes without important consumer protections.

What is a non-qualified mortgage?

A non-qualified mortgage is a type of mortgage that doesn’t conform to certain standards set by the Consumer Financial Protection Bureau (CFPB). These standards mandate certain features loans may (or may not) have, and delineate certain practices lenders must follow in evaluating applicants’ finances and ability to repay. Asset-based loans and no-income loans are common examples of non-QM loans.

In the case of mortgages, non-QM lenders have more flexibility in underwriting guidelines. They will work with borrowers whom conventional lenders might deem too risky because of their non-salaried income, their low credit score or their blotted credit history — or who just don’t fit the qualified-mortgage criteria.

What are the features of a non-qualified mortgage?

Non-QM loans feature looser income and credit requirements. For example, instead of W-2 forms and paystubs, borrowers may be able to use alternative methods of income documentation, such as tax returns, bank/investment account statements (or other proof of assets), rental income or 1099s, to demonstrate their ability to repay the loan.

Borrowers’ debts may consume a greater percentage of their income than the standard amount conventional lenders like to see — as much as 50 percent.

In some cases, there is no waiting period after bankruptcy or foreclosure, enabling individuals to secure a mortgage soon after these events.

How does a non-qualified mortgage differ from a qualified mortgage?

A qualified mortgage (QM) is a type of loan that adheres to specific guidelines set by the CFPB. These guidelines are designed to ensure that the borrower can afford the loan and include restrictions on negative amortization, interest-only payments and balloon payments, among others. QMs also have loan terms that do not exceed 30 years and require verification of your income and assets.

​​The QM rule has four key directives lenders must follow:

The “ability-to-repay” rule

Lenders must ascertain whether a borrower can truly afford a loan before giving them any financing — by verifying and documenting certain aspects of the individual’s personal finances (the “underwriting” process). The ability-to-repay rule requires a lender, at a minimum, to evaluate loan applications on these eight components:

• Current income/assets
• Current employment status
• Monthly payment for this mortgage loan
• Monthly payment on any simultaneous loan that’s secured by the home such as a piggyback mortgage (usually taken out when a borrower doesn’t have enough cash for a down payment)
• Monthly payment for mortgage-related obligations
• Current debt obligations, alimony and child support
• Monthly debt-to-income ratio or residual income
• Credit history

Restrictions on risky features

These include:

• Loan terms longer than 30 years
• Interest-only payments without paying down the principal
• Balloon payment (a big lump-sum payment at the end of a loan term)
• Negative amortization, which allows your loan balance to increase over time

Caps on fees and points

Lender fees and points can dramatically increase your borrowing costs. For loan amounts that exceed $100,000, lender fees and mortgage points cannot exceed 3 percent of the loan amount.

Limits on debt-to-income ratio

Expressed as a percentage, the debt-to-income (DTI) ratio is derived by dividing all of your monthly obligations by your pre-tax monthly income. In most cases, a qualified mortgage borrower is limited to a 43 percent DTI ratio.

In contrast, non-QM loans are not subject to these same rules and regulations. They typically have less stringent requirements for credit scores, debt-to-income ratios and repayment schedules. However, they can also feature longer-than-30-year terms, balloon payments and higher fees.

Is a non-qualified loan the same as a non-conforming loan?

Non-qualified loans and non-conforming loans are not the same thing. Both refer to mortgages that are outside the typical sort of loans most homebuyers get. But they are outside two different sets of rules; in other words, they differ in the standards that they are not adhering to.

• A non-QM loan doesn’t conform to the standards set by the CFPB to protect consumers from predatory lending practices — and to ensure they don’t take out loans they won’t be able to repay.
• A non-conforming loan doesn’t meet (or conform) to the criteria set by the Federal Housing Finance Agency (FHFA). As a result, it is not eligible for purchase on the secondary mortgage market by Fannie Mae and Freddie Mac, the two government-sponsored enterprises that buy most of the home loans originated in the U.S. Chief among the FHFA’s criteria: The loan can’t exceed a certain amount — $766,550 in most parts of the U.S. in 2024.

There is overlap in the FHFA’s and the CFPB’s standards, especially in the borrower’s finances and creditworthiness. Conforming loans often require applicants to have a DTI of no more than 43 percent, proof of salaried income and a certain credit score, for example. If a loan has other non-traditional features, such as having a term other than 15 or 30 years, or requiring no down payment, it is usually non-conforming, too.

Basically, non-conforming loans are a category of non-QM loans that don’t fit into the typical mortgage framework.

Who can benefit from non-qualified mortgages?

While CFPB’s Qualifying Loan standards are intended to safeguard consumers, they can sometimes seem exclusionary to those whose financial profiles don’t fit the norm. Borrowers who’ve tried getting a conventional or government-insured loan and were turned down may find what they’re looking for working with a non-QM lender.

Here’s who may benefit most from a non-QM loan:

• Self-employed borrowers: These borrowers generally have sporadic pay and multiple income streams, making it hard to get a qualified mortgage. Many self-employed, non-QM borrowers get bank statement loans, which are based on their cash flow and liquid assets (rather than relying on W-2s).
• Real estate investors: These are the folks who fix-and-flip homes, or who rent out and generate an income from the homes they buy, and need funding quickly. Investors are exempt from the ability-to-repay rule, usually because they sell the homes they buy quickly, or they rely on rental income to repay the mortgage. DSCR loans (short for debt service coverage ratio) and asset depletion home loans (in which you tap the equity in your primary residence to fund the purchase of another property) often accommodate this sort of borrower.
• Foreign nationals: Non-resident borrowers who want to purchase property in the U.S. might not qualify for a traditional loan because of a low or non-existent U.S. credit score. Non-QM lenders use international credit reports and letters from creditors to qualify this group for a foreign national home loan. Mitigating factors, such as a high income, robust liquid assets and a large down payment, also help foreign borrowers qualify for non-QM loans.
• Prime borrowers: Borrowers who have pristine credit but are in search of a loan with certain features, such as interest-only payments or a debt-to-income ratio limit above the standard 43 percent, are considered “prime non-QM borrowers.”
• Near or non-prime borrowers: In many cases, these are borrowers who have insufficient credit, or a prior bankruptcy or recent distressed property sale within the last two years. Lenders tend to require more money down and may have tighter standards elsewhere to lessen the credit risk.
• Borrowers with significant assets: A type of non-QM loan, called an asset qualifier loan, is ideal for borrowers with prime credit and substantial assets. Although the assets are enough to buy the home outright, a borrower may decide to finance the purchase to maintain positive cash flow. Credit invisibles — people who have considerable assets but who lack a long credit history or credit score (because they don’t use credit cards) — are good candidates too.

How do lenders verify income for non-qualified loans?

While the process for verifying income for a qualified loan typically involves reviewing tax returns, W-2s and pay stubs, the process for non-QM loans is slightly different. Using manual underwriting, lenders may allow borrowers to demonstrate their ability to repay the loan using alternative forms of income documentation, such as bank/investment account statements, 1099s, receipts from rents or leases or other business receivables.

What are the drawbacks of a non-QM loan?

Non-QM loans can be a viable alternative to conventional financing — but these benefits come at a cost. Non-QM loans typically have higher down payment requirements (as much as 25 percent of the home price) and interest rates.

As for rates, spreads above qualifying mortgages can be as little as 0.25 percent and as much as 5 percent, depending on the terms of the transaction and the creditworthiness of the borrower. Non-QM 30-year fixed rate loan rates are typically a percent or two higher than the prime 30-year fixed mortgage rate, according to Fitch Ratings.

The stiffer terms exist to compensate the lender for the additional risk they’re taking on — since Fannie Mae and Freddie Mac cannot purchase non-QM loans.

Pros

• Easier to obtain
• Open to non-traditional borrowers
• More flexible terms

Cons

• Harder to find (reputable lender)
• Higher interest rate, down payment
• Potentially tougher to repay

Also, the lender still has to do some due diligence on the borrower. It faces the risk of a CFPB enforcement action if the borrower’s ability to repay is not accurately verified.

Finally, the loan could be riskier for the borrower. There’s a reason the CFPB frowns on features like balloon payments and interest-only repayments — they can blow up in a borrower’s face, increasing the likelihood of delinquency and default. At the very least, the non-QM loan is likely to be more expensive than a traditional mortgage of comparable size and term.

Where can you get a non-QM loan?

If you’re interested in a non-QM loan, there are several places you can turn to. Start by determining your eligibility — typically, you’ll need a minimum credit score of 620, stable income and a consistent employment history.

Once you’ve confirmed your eligibility, you can then search for a lender that offers non-QM loans Many mortgage brokers work with non-QM wholesale lenders, so they might be a good resource.

When you find a lender, ask if they’ll first run you through an automatic underwriting, just to make sure you couldn’t get a qualifying loan after all. Also ask lenders whether they originate their own non-QM loans, or if the loan is backed by another company that will service your loan. Take the time to understand what fees you’ll pay, as well as any special loan terms or features that might add to your overall borrowing costs.

You should always fully understand the terms of your mortgage. But it’s especially important to read the fine print and be aware of the worst-case scenario of any non-qualifying loan you consider.