In the 2015 Academy Award–winning film The Big Short, there’s a scene in which actress Margot Robbie sips champagne in a bubble bath and explains the origins of the 2008 financial crisis. At the root of the crisis, she explains, was the practice of banks bundling an increasing number of subprime mortgages into bonds. “Whenever you hear subprime, think ‘shit,’” is how she puts it.
To help prevent history from repeating itself, Congress passed a rule in 2010, as part of the Dodd-Frank Act , to clamp down on the excessive risk-taking in the mortgage industry prior to 2008. The rule, which went into effect in January 2014, created something called a “qualified mortgage.”
Basically, a qualified mortgage is a type of loan that has certain, more stable features that help make it more likely that the borrower actually is able to repay their loan. This means the bank has to do some more in-depth work to make certain that a borrower can repay the loan, such as analyzing the borrower’s “ability to repay .”
It doesn’t necessarily mean more work for the borrower, but it does mean lenders will take a deeper dive into a potential borrower’s finances to better determine whether the mortgage they applied for is considered affordable for them under the guidelines. The rule is intended to protect consumers from harmful practices, but it may also make it harder to qualify under certain loan programs. Unfortunately, not everything in the financial world comes with a Margot Robbie explanation. Since the terminology around qualified and non-qualified mortgages can get confusing, here are a few basics.
What Is a Qualified Mortgage?
Qualified mortgages follow three basic tenets, as outlined by the Consumer Financial Protection Bureau (CFPB):
1. Borrowers should be able to pay back their loans.
2. A qualified mortgage will likely be easier for the borrower to understand.
3. The qualified mortgage should be a fair deal for the borrower.
Based on these simple ideas, the CFPB created stricter guidelines for loans not sold to Fannie Mae (FNMA) or Freddie Mac (FHLMC) to ensure that borrowers could repay loans. FNMA and FHLMC are government-sponsored entities (GSEs)—this designation allows them a special pass on QM rules, commonly referred to as the “QM GSE Patch .” The conforming loans that follow GSE guidelines are normally input by lenders and approved in the automated underwriting systems set by FNMA and FHLMC.
For QM loans not approved and sold to FNMA or FHLMC, there is a limit on how much of a borrower’s eligible income used for qualifying can go toward debt. In general, total monthly debts cannot exceed 43% of gross monthly income, this is referred to as a debt-to-income ratio or DTI.
Limiting the amount of debt a borrower can take on can make them a safer bet for banks and less likely to default on their mortgage. Instead of granting a mortgage that’s possibly not affordable, keeping the loan within a reasonable DTI ensures a borrower is not borrowing more money than they can repay.
Next, the loan term must be no longer than 30 years. Once again, this is in place to protect the home buyer. A loan term beyond 30 years is considered a riskier loan because of the extended loan term with longer payback and additional interest. In addition, a qualified mortgage is barred from some other risky features, such as:
• Interest-only payments. Interest-only payments are payments made solely on the interest of the loan, with no money going toward the paying down the principal. When a borrower is only paying interest, they don’t make a dent in paying off the loan itself.
• Negative amortization. Amortization means “paying off a loan with regular payments, so the amount goes down with each payment.” In the case of negative amortization, the borrower’s monthly payments don’t even cover the full interest due on the mortgage. The unpaid interest then gets added to the outstanding mortgage total, so the amount owed actually increases over time. In some cases, depending upon market conditions, a borrower could end up owing more than the home is worth.
• Balloon payments. These are large one-time payoffs due at the end of the introductory period of the loan, historically 5 or 7 years. These loans are fully amortizing during the full term and are unlikely to carry any sort of prepayment penalty.
In this example, we will refer to points as origination discount points. Origination discount points can vary based on many things such as lender, loan program, rate chosen, but a qualified mortgage will have a cap on the number of total points allowed to be charged to the consumer.
According to the Consumer Financial Protection Bureau , effective in 2017, the maximum total points and fees a borrower could be charged are limited to the following without being referred to as a high priced mortgage which carries additional guidelines:
• For a loan of $100,000 or more: 3% of the total loan amount or less
• For a loan of $60,000 to $100,000: $3,000 or less
• For a loan of $20,000 to $60,000: 5% of the total loan amount or less
• For a loan of $12,500 to $20,000: $1,000 or less
• For a loan of $12,500 or less: 8% of the total loan amount or less
Lenders also verify a borrower’s ability to repay the loan. The ability-to-repay rule encompasses different aspects of a borrower’s financial history that a lender must review. The ability-to-pay rule means the lender is likely to review items such as:
• Credit history
• Alimony or child support, or other monthly debt payments
• Other monthly mortgages
• Mortgage-related monthly expenses (PMI, HOA fees, taxes)
Under some circumstances, lenders might not have to follow the ability-to-repay rule but still count the loan as a qualified loan. These lenders and institutions may include:
• Groups certified by the U.S. Treasury Department to provide mortgage services to underserved populations
• Nonprofit service groups that receive aid from HUD to make down payments affordable in developing communities
• Small nonprofit organizations that lend to a select number of low- to moderate-income consumers each year
• State agencies that provide low rates and down payment assistance
• Any loans made through the assistance of the Emergency Economic Stabilization Act
In addition to the protections provided to borrowers, the rule also grants lenders safe harbor through verification of the borrowers ability to repay by limiting the ability of borrowers who can’t pay their mortgages from suing the lender. Qualified mortgages offer safe harbor to the lender if ability to repay rules were properly adhered to when qualifying the borrower(s) for the requested loan program.
In these instances, borrowers cannot sue based on the claim that the institution had no basis for thinking they could repay their loans. They also make it harder for borrowers to buy more home than they can afford.
While qualified mortgages include a more involved process, they’re ultimately meant to protect both the lender and the borrower.
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What Is a Non-Qualified Mortgage?
A non-qualified mortgage (non-QM) is a home loan that does not meet the standards required for a qualified mortgage.
But a non-QM loan is not the same as the subprime loans available before the housing market crash. Typically, with a non-QM loan, lenders confirm that borrowers can repay their loans based on reasonable evidence, which can include verifying many of the same information as QM loans such as assets, income, or credit score.
Non-QM loans allow lenders to offer loan programs that don’t necessarily meet the strict requirements of qualified mortgages. Because non-QM loans don’t have to adhere to the same standards, it means the underwriting requirements like the QM DTI limit for instance, can be more flexible and provide eligible borrowers with more loan program choices.
Non-qualified loans can also vary by lender, so borrowers who take this route should research their options carefully.
Not all lenders are built the same, similar to borrowers. In some situations a non-QM loan might be the right choice for a borrower.
When Could a Non-QM Loan Be the Right Option?
Many lenders offer non-QM loan programs because they have more flexible loan features. This type of loan may be right for borrowers who can afford to pay but don’t conform to additional qualified-mortgage requirements.
Examples of borrowers who might seek a non-qualified mortgage are:
• The self-employed. Borrowers with streams of income that might be difficult to document, like freelance writers, contractors, and others, might consider a non-qualified mortgage.
• Investors. People investing in real estate properties, including flips and rentals, might choose to apply for a non-qualified mortgage because they need funding faster, or have a challenging time proving income from their rental properties.
• Non-U.S. residents. People who are not U.S. residents can be challenged by qualified mortgages, because they may have a low or nonexistent credit score in the U.S.
Qualified mortgages have safeguards in place for both the lender and the borrower, but in some circumstances, it can make sense for a borrower to choose a non-qualified mortgage. In some instances, this type of loan may be chosen because of property issues such as a condo that doesn’t meet certain criteria, property type, etc.
If you are looking for a mortgage to fit your financial needs, you could check out SoFi’s home loans. Borrowers can put as little as 10% down for loans up to $3 million, and with competitive rates and dedicated mortgage loan officers, applying for a new home might be easier than you think.
While the nitty-gritty of qualified mortgages versus non-qualified mortgages might not be as fun or thrilling as a Hollywood blockbuster, deciding the route to take as a borrower is an essential and important step of the home-buying process, so do your research and ask your chosen lender questions about the different loan programs available.
Understanding the differences between the qualified and non-qualified mortgage programs might make choosing the best loan fit for your needs easier. The process of securing a mortgage has changed considerably in the past decade, but policies have been put in place to ensure better protections and in turn, a better experience for the borrower.
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