Understanding qualified vs. nonqualified mortgages
Defining qualified and nonqualified mortgages
- Qualified mortgages meet standards established by the Consumer Financial Protection Bureau.
- The standards are meant to ensure that lenders have done their due diligence on whether the borrower can repay the loan.
- Nonqualified mortgages are not risky per se and may make sense in certain situations.
The mortgage industry has a host of rules governing how loans are underwritten and issued. While they are mostly the responsibility of your lender, these regulations can influence your loan conditions and eligibility. One of the key criteria lenders must consider when issuing home loans is whether they are qualified or nonqualified mortgages.
The Dodd-Frank Act was passed in 2010 to clamp down on the predatory lending practices that led to the 2008 financial crisis. The legislation established the Consumer Financial Protection Bureau (CFPB), which enforces the Ability to Repay rules created under Dodd-Frank as well as the qualified and nonqualified mortgage standards, also a product of Dodd-Frank.
The regulations are meant to protect both lenders and borrowers by putting the brakes on mortgage originations that have a high risk of default.
What is a qualified mortgage?
Lenders that issue qualified mortgages are eligible for safe-harbor protections. Safe harbor means that if a lender originates a qualified mortgage, it cannot be sued by a borrower who defaults and claims that the loan was beyond his or her ability to repay.
The idea is that enough due diligence has been completed for a qualified mortgage to ensure that both the borrower and lender are acting in good faith. Qualified mortgages must meet the following basic requirements:
- Maximum borrower debt-to-income ratio of 43 percent;
- Fees and discount points limited to 3 percent of the total loan amount;
- Maximum loan term of 30 years;
- Interest rates capped at set number of percentage points above the prime rate; and
- An absence of high-risk loan conditions, such as balloon payments, negative amortization and interest-only periods.
Qualified mortgages are different from conforming mortgages, although qualified mortgages, or QMs, typically also can be sold in the secondary market to the government-sponsored enterprises Fannie Mae and Freddie Mac.
Given the limit on rates and fees, the added protection of the safe harbor provision, and the ability to sell the mortgage in the secondary market and remove it from a lender’s books, QMs tend to be less costly than nonqualified mortgages. Still, there is reason to consider a nonqualified mortgage.
What is a nonqualified mortgage?
Nonqualified mortgages — often called out-of-the-box loans — do not meet the CFPB’s QM criteria. Yet this does not necessarily mean that they are risky loans.
Mortgages oftentimes are deemed nonqualified because the borrower’s debt-to-income ratio is too high. This can be a result of several unexceptional factors, such as an individual having a relatively low income but a large volume of financial assets.
A loan can also be deemed nonqualified if the borrower recently faced a foreclosure or bankruptcy. Individuals with such a credit incident in their past are eligible to obtain nonqualified mortgages immediately, as opposed to the two to three-year wait period for a qualified mortgage.
Lenders also may choose to issue nonqualified loans in higher-risk scenarios where QM standards can’t be met. A nonqualified mortgage allows the lender to charge higher fees or establish interest-only payment arrangements for the loan. To make up for the increased risk, borrowers seeking nonqualified mortgages typically face a more stringent approval process as well as higher interest rates than do borrowers seeking qualified mortgages.
Because a nonqualified mortgage typically cannot be sold to Fannie or Freddie, lenders want to ensure that the loan will be repaid if it is to remain in their portfolio for the next few decades.
How do they impact the consumer?
Whether a mortgage is qualified or nonqualified is largely the concern of your lender, because it is the lender that is responsible for the compliance burden. If your home loan is being reviewed as a qualified mortgage, you may face more paperwork in order to help your lender confirm your ability to repay.
If you do not meet the eligibility requirements for a qualified mortgage, you may face the tougher approval standards and the higher cost of a nonqualified mortgage. In many cases, you may not even hear the terms qualified and nonqualified mortgages used in the mortgage-approval process, but understanding how they are defined can provide some insight into the mortgage-approval process as you compare lenders.