James DeFrantz1
James Defrantz May 16, 2016

The case for non-qualified mortgages

Beginning in January of 2014, the Ability to Repay (ATR)/Qualified Mortgage (QM) Rule took effect, which establishes a standard to differentiate “qualifying” and “non-qualifying” residential mortgage loans. Since that time, many lending institutions have defaulted to making only qualifying loans.

However, several prudential regulators have made it clear that avoiding nonqualified mortgages was not the intention of the regulation. On the contrary, there are several legitimate reasons why “thinking outside the box” and making non-qualified mortgages should be considered.

Under the rule, the following requirements define a qualified loan:

  • The borrowers debt-to-income ratio cannot exceed 43%;
  • The points and fees on the loan cannot exceed the cap established in the regulation, which can vary depending on the size of the loan;
  • May not have balloon payments;
  • May not contain interest-only payments;
  • May not exceed 30 years.

When loan terms do not meet these parameters, then the loan is considered non-qualified and a lender must meet the ability-to-repay standards. These include specific components that are designed to document that a lender has established the borrower’s ability to repay a loan when its interest rate and fees are at their peak.  

For the purposes of this discussion, it is important to note that borrowers who require non-qualified loans fit into two rather extreme categories. At one end are very wealthy borrowers who may have highly liquid assets, but irregular income. Or perhaps these borrowers want a “bridge” loan to buy a house while they await completion of a large business transaction that will result in an influx of cash. For these borrowers the need for non-qualified mortgages is largely an accommodation.

The second category consists of first-time homeowners in low- to moderate-income areas. These borrowers tend to be outside of the qualified loan parameters through economic circumstances that without some level of assistance will result in continued struggle. It is this second set of borrowers that we have in mind in the remaining discussion.

So, from the lender perspective, here are some benefits of making non-qualified mortgages to these first-time homeowners:

Increased interest margins. Non-qualified loans generally present a higher level of risk than qualified loans. As a result, higher loan fees and rates are appropriate. Remember that the regulations require that the lender must prove that they have documented the borrowers’ ability to repay the loan. The calculation must be made while considering the worst case scenario for the borrower which, in this case, means when all the highest interest rates and fees have kicked in.

When considering these loans, it is also important to remember that even though there is a higher risk, with proper underwriting, the performance of loans in lower- to moderate-income neighborhoods is actually equal to or better than the performance in other neighborhoods, according to a study conducted by the Federal Reserve.

Reduced competition. Just because so many financial institutions have eschewed the non-qualified mortgage doesn’t mean that the need for these loans has disappeared. In fact, the fear of what might happen with non-QMs has left a void. This has resulted in a demand for non-QMs and the lender who decides to enter the market can choose among the best.

Minimal infrastructure changes. The whole point of the ATR rule is that lenders must develop sound systems for determining that a borrower can repay a loan. The essence of the regulation is acting in a safe and sound manner. For those institutions that wish to thrive and survive, safe and sound policies and procedures should be a daily practice. The steps that are required to meet the ATR rule should be second nature.

Meeting the credit needs of the community. Many lenders talk about meeting the credit needs of the community in their Community Reinvestment Act(CRA) statements. Of course, more often than not, this statement is theoretical and can’t really be documented. A program that helps first-time homebuyers with a legitimate chance at asset acquisition constitutes one of the largest credit needs of most communities. There are a number of institutions that have recognized this need and have developed successful lending programs coupled with credit counseling. For example, both Time Federal Savings of Medford, Wis. and Geddes Federal Savings in Syracuse, N.Y. have implemented non-QM programs for first-time homebuyers with unquestioned success.

The CRA rewards innovation. For lending institutions that are subject to the CRA, there is a strong regulatory encouragement for innovative lending practices. The development of a lending program that allows non-traditional borrowers to obtain mortgages can lead to an outstanding CRA rating.

In the end, there is absolutely no reason to run away from non-qualified mortgages. The potential for good results far outweighs the risk.

Mr. Defrantz is a principal at Hayward, Calif.-based Virtual Compliance Management. He can be reached at jdefrantz@vcm4you.com

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