What is a Qualifying Mortgage?
A qualifying mortgage is a loan with certain more stable characteristics that help make it more likely that the borrower will repay the loan.
This doesn’t necessarily involve more work on the part of the borrower, but it does mean that the lender will gain a deeper understanding of the potential borrower’s financial situation.
Lenders will analyze factors such as a borrower’s repayment ability to better determine whether the mortgage they are applying for meets the guidelines.
The rule, designed to combat excessive risk-taking in the pre-2008 mortgage industry, was designed to protect consumers from harmful practices. However, it can also make it more difficult to qualify for certain loan programs.
How Qualified Mortgages Work
Qualifying mortgages follow three basic principles outlined by the Consumer Financial Protection Bureau (CFPB):
- The borrower should be able to repay the loan.
- Qualifying mortgages should be easier for borrowers to understand.
- A qualifying mortgage should be a fair deal for the borrower.
Based on these ideas, the CFPB established stricter guidelines for loans not sold to Fannie Mae or Freddie Mac to ensure that borrowers can repay their loans.
With these loans, there is a limit to how much of a borrower’s qualifying income can be used to pay down debt. Generally, total monthly debt cannot exceed 43% of a borrower’s gross monthly income, a percentage known as the debt-to-income ratio (DTI).
Limiting the amount of debt borrowers can take on makes them safer bets for banks and less likely to default on their mortgages. Keeping loans within a reasonable DTI range ensures that borrowers do not borrow more than they can repay.
Second, the loan term for qualifying mortgages must not exceed 30 years. Again, this is to protect homebuyers. Loan terms longer than 30 years are considered riskier loans, as extended terms mean longer returns and additional interest — both key considerations when choosing a mortgage term.
Additionally, qualifying mortgages are prohibited from having a number of other risk characteristics, such as:
- Interest-only payments: An interest-only payment is a payment based entirely on the interest on the loan, with no money used to pay back the principal. When borrowers pay interest only, they have no effect on paying off the loan itself.
- Negative Amortization: With amortization, the loan amount decreases with each regular payment, as shown when using the mortgage calculator. However, with negative amortization, the borrower’s monthly payments don’t even cover the full interest on the mortgage. The unpaid interest is then added to the total outstanding mortgage payment, so the amount owed can actually increase over time. In some cases, depending on market conditions, the borrower may end up owing more money than the home is worth.
- Balloon repayments: These are large lump sum payments due at the end of the loan introduction period, historically after five to seven years.
Additionally, qualifying mortgages have certain limits on the points and fees lenders are allowed to charge. Lenders can charge up to the following maximum fees and points for qualifying mortgages; otherwise, it’s called an overpriced mortgage, which has additional guidelines:
- For loans of $100,000 or more: 3% of the total loan amount
- For loans of $60,000 to $100,000: $3,000
- For loans of $20,000 to $60,000: 5% of the total loan amount
- For loans between $12,500 and $20,000: $1,000
- For loans of $12,500 or less: 8% of the total loan amount
In addition to points and fee caps, there are limits on the annual percentage rate (APR) for qualifying mortgages. This threshold may vary depending on the size or type of loan.
Finally, lenders must verify a borrower’s ability to repay the loan, so they aren’t immediately scrambling to find ways to lower their mortgage payments. The solvency rules cover different aspects of the borrower’s financial history that the borrower must review. Specifically, lenders may review the following items:
- income
- assets
- Employment
- credit history
- Alimony or child support, or other monthly debt payments
- Other monthly mortgages
- Monthly mortgage-related expenses (such as private mortgage insurance, homeowners association fees, or taxes)
However, in some cases, the lender may not have to comply with solvency rules and the mortgage can still count as a qualifying loan.
In addition to the protections afforded to borrowers, the rule also provides some protections to lenders. Qualified mortgages provide a safe harbor for lenders if the ability to repay rules are properly followed in qualifying the borrower for the requested loan program.
In these cases, the borrower cannot sue on the grounds that the agency has no reason to believe they can repay the loan. The rules also make it harder for borrowers to buy more homes than they can afford.
What is a non-qualified mortgage?
A non-qualifying mortgage (non-QM) is a type of mortgage that does not meet the criteria for a qualifying mortgage, as described above.
However, non-QM loans are not the same as the subprime loans that were available before the housing market crash. Typically, for non-QM loans, the lender will confirm based on reasonable evidence that the borrower can repay the loan. This may include verifying much of the same information as a qualifying mortgage, such as assets, income or credit score.
Non-qualifying mortgages allow lenders to offer loan programs that do not necessarily meet the strict requirements of qualifying mortgages. Since non-QM loans do not have to adhere to the same standards, this means that underwriting requirements (such as qualifying mortgage DTI limits) can be more flexible.
The upside is that this opens up more loan program options for eligible borrowers. That being said, non-eligible loans can vary from lender to lender, so borrowers who take this route should research their options carefully and take advantage of tools like a home affordability calculator to help ensure they don’t get stuck.
When is a non-QM loan the right choice?
While qualifying mortgages offer protection to both lenders and borrowers, there are certain circumstances in which it may make sense for a borrower to opt for a non-qualifying mortgage.
Many lenders offer non-QM loan programs because they have more flexible loan features. In some cases, a borrower may choose a non-QM loan because of a property issue, such as an apartment that does not meet certain criteria or a certain property type.
This type of loan may be suitable for borrowers who can afford the mortgage payments but do not meet the additional qualifying mortgage requirements. Examples of borrowers who may seek non-qualified mortgages include:
- Self-Employed: Borrowers whose sources of income may be difficult to document, such as freelance writers, contractors, and others, may be considered for non-qualifying mortgages.
- Investors: People investing in real estate (including flips and rentals) may choose to apply for a non-qualified mortgage. This could be because they need faster funding or have difficulty proving income from their rental properties.
- Non-U.S. Residents: Non-U.S. residents may find it difficult to meet the requirements for a qualifying mortgage as their credit score in the U.S. may be low or non-existent
While understanding the nature of qualified versus non-qualified mortgages can be overwhelming, understanding the differences and other mortgage basics may make choosing the loan that best suits your needs easier. It is important to do your research and ask your lender questions about the different loan programs available.