What is a nonconforming loan?
The term nonconforming loan is a broad term referring to any type of mortgage loan that doesn't meet the standards described in the previous section. This includes, but isn't necessarily limited to:
- Jumbo loans: A jumbo loan is one that doesn't qualify as conforming because it exceeds the applicable FHFA loan limit.
- Bad credit loans: There are investment property lenders that welcome borrowers with credit scores significantly lower than Fannie Mae's standards.
- Asset-based loans: In recent years, there has been a surge in asset-based lending. These loans are primarily based on the qualifications of the property, not the borrower. Typically, an asset-based lender will check the borrower's credit score, but factors like personal debts and income don't come into play.
- Low-down-payment loans: It's possible to find investment property mortgages for properties with two to four units with less than a 25% down payment, but these will be nonconforming.
- Loans to businesses: Conforming loans generally have to be made to you as an individual. If you want to borrow money through an LLC or other business entity, you'll likely have to pursue a nonconforming loan.
Which is better: conforming or nonconforming loans?
If you can qualify for a conforming loan, that is usually the best way to go. Origination fees tend to be lower than those charged for nonconforming investment property loans. And while investment property loan interest rates are almost always higher than you could get for a primary residence mortgage, you can expect a smaller difference if your investment property loan is conforming.
On the other hand, it can be difficult to get a conforming loan, especially if you're in a high-cost market. For example, if you want to buy a duplex in San Francisco, it can be very hard to find one for less than the $980,325 limit that applies to high-cost areas.
Debt-to-income is also a big obstacle for many borrowers. The 45% maximum debt-to-income ratio allowed by Fannie Mae's standards includes mortgage payments on your primary home (and any other real estate), as well as your other monthly debt obligations such as auto loans, student loans, credit cards, and other installment debts. You might be able to use some of the property's expected rental income for qualification purposes, but it's not likely to help tremendously.
On the other hand, it can be just as difficult (if not more so) to qualify for a nonconforming loan. In simple terms, if your loan is nonconforming for one or two reasons, the rest of your qualifications might need to be even better. For example, I know of an investment property lender that will make 80% LTV loans on 2- to 4-unit properties, but only for borrowers with credit scores above 720.
Plus, with a nonconforming loan, you can expect to pay a higher interest rate. As a personal example, at a time when 30-year fixed-rate mortgages on owner-occupied properties averaged a 3.7% APR, I received an offer for a conforming investment property mortgage with a 4.625% interest rate. Meanwhile, the best I found from an asset-based lender at the same time was 6.25%.
If you want to borrow through an LLC, your DTI is over 45%, or you want to buy a $2 million property, just to name a few examples, a nonconforming loan is obviously the better (and only) choice. On the other hand, if you can qualify for a conforming loan, it's likely to come with a lower interest rate, as well as an easier approval process. The bottom line is that there's no universal right answer to the "which is better" question. It depends on your situation.