What Is a Non-Qualified Mortgage?

If you hope to buy a home but worry that you can't qualify for a traditional mortgage, a non-qualified mortgage offers another option. Here, we'll unpack how a non-qualified mortgage works, and help you decide if a non-qualified mortgage is the right choice for you.

A non-qualified mortgage (non-QM) is a home loan designed to help home buyers who can't meet the strict criteria of a qualifying mortgage. For example, if you are self-employed or don't have all the necessary documentation to qualify for a traditional mortgage, you might need to look at non-qualified mortgages.

The best way to understand a non-qualifying mortgage is to look at the criteria for traditional, qualifying mortgages. To qualify for a traditional mortgage, you must meet these requirements:

• Income: You must have verifiable income, including pay stubs, W-2s, and tax returns.
• Debt: Your debt-to-income ratio (DTI) must be 43% or less. This is the amount of your monthly income that goes toward your existing debts.
• Limits on fees: Points and fees on your loan cannot exceed 3% of the loan amount.
• No risky loan features: Risky features include interest-only loans (where you only pay interest without reducing the principal), negative amortization (where your principal can increase, even while you are making payments), or balloon payments (where a larger payment can be tacked on to the end of the loan).
• Loan term: The loan term must be 30 years or less.

If you can't tick all of the above boxes, you'll need to look into non-qualifying mortgages.

Essentially, mortgage lenders need to know you have the ability to repay your loan. The above regulations also protect buyers from risky loans. These minimum standards for qualified mortgages are part of the 2010 Consumer Protection Act and Dodd-Frank Wall Street Reform Act.

Why do these regulations exist? In the years leading up to the Great Recession, lenders seemed willing to approve mortgages for anyone with a pulse, including those with poor credit and low down payments. Some mortgages did not verify income at all. Unethical lenders would crowbar home buyers into mortgages that were unaffordable. This willy-nilly approach was one of the reasons the recession hit with such ferocity. Millions of people who had home loans could not afford the payments.

Today, as long as lenders follow these strict lending guidelines, they are protected from liability. Borrowers cannot come back (as many did during the Great Recession) and claim that a lender knew they could not make the monthly payments.

Non-qualified mortgages are not backed by government agencies like FHA, VA, Fannie Mae, and Freddie Mac.

There is a lot to consider when choosing a mortgage. Here's a quick rundown of the pros and cons associated with a non-QM.

One of the primary benefits of a non-QM loan is that it allows buyers with low credit scores to purchase a home. They require less proof of income for people who are self-employed, run their own businesses, or work non-traditional jobs. Non-QMs are also almost as easy to apply for as a traditional loan.

A non-QM is a good idea when you have the income to make regular, on-time mortgage payments, but cannot get a qualifying mortgage.

Imagine that you own a contracting business. Some months, your income is high and others, only a little goes into your bank account. You have no way of knowing exactly how much you will earn from year to year. But you don’t have trouble paying your bills, your credit score is high, and you have money in the bank. Even though your finances are healthy, you cannot tick the "income verification" box required for a qualified mortgage. That's where a non-QM comes in.

The type of borrower who might benefit from a non-QM loan includes:

• Retiree
• Self-employed
• Real estate investor
• Business owner
• Foreign national
• Buyer who lives off investments, or has high assets and low income
• Buyer with a high debt-to-income ratio
• Buyer with less-than-perfect credit

Non-QMs illustrate that mortgages are open to many types of home buyers. You can get a mortgage with bad credit, or if your income is low, or if you have a high DTI.

If you're concerned about whether a non-QM is safe, it's good to know that they are not the same as subprime mortgages. The Great Recession housing meltdown has led to a misconception that non-QMs are bad loans. However, like qualified mortgages, today's non-QMs have their own set of guidelines. In fact, the lending process is similar, apart from the loan documents required. Both loan types are subject to the "Ability to Repay Rule." Unless a lender goes out of its way to determine that a borrower is able to repay the loan, they are open to lawsuits. A non-QM is as safe as other mortgages.

• Credit unions: A great mortgage loan may be as close as your nearest credit union, even if you can't qualify for a traditional loan. Credit unions are authorized to issue non-qualified mortgages. They are less likely to want to sell your mortgage and -- as you're a member-owner rather than just a customer -- a credit union may be more willing to work with you if you don't tick all the normal boxes. As long as you qualify to join (for example, some credit unions are for tradespeople only, while others serve specific communities), a credit union offers a host of benefits.
• Mortgage lenders for bad credit: If it's your credit score holding you back, there are mortgage lenders who routinely work with people with credit scores in the high 500s. You can expect to pay more in interest and fees than you would with a qualifying mortgage, but it may open the door to homeownership.

If your credit score is low or your income is difficult to prove, you do have another option. Before you give up on buying a home, consider an owner financed property. If the situation that prevents you from obtaining a qualifying mortgage will pass in a few years (for example, a bankruptcy will fall off your credit report, or your DTI will be lower), consider looking for a home that the current owners are willing to finance. This is how it works: You agree on terms, like how long the owner will act as a lender and the interest rate you will pay. You make a down payment, but rather than making monthly payments to a mortgage lender, you pay the previous owners. Like a financial institution, the previous owner can repossess your home if you default on the loan.

Owner finance arrangements are not without risks. They normally include a "balloon payment," due three to five years down the road. At that point, you apply for a traditional mortgage and use the funds to pay the previous owner in full. Once the previous owner is out of the picture, you make your monthly payments to the new lender.

If you're looking for a non-QM loan, make it a point to rate-shop current mortgage rates until you find the perfect mortgage for you. Taking the time to find the right loan can save you thousands of dollars over time.

Still have questions?

Read more about non-qualified mortgages: