You might have heard that there are “qualified” mortgages and “non-qualified” mortgages. What do these terms mean, and how much should you care if you're a first-time home buyer? The answer: Alot.
History of the Qualified Mortgage
After the mortgage-related financial crisis of 2008, the newly created Consumer Financial Protection Bureau (CFPB) examined which loans failed and determined that if certain features were present in mortgage contracts, borrowers were much more likely to default on their loans, and ultimately lose their homes to foreclosure.
In other words, they asked why certain loans failed and how they could prevent mass failure in the future.
They also noted that many of these foreclosed loans resulted in lawsuits. Borrowers claimed that the lenders should have known that they would not be able to pay the loans back, and should never have made the loans in the first place. In many cases, they had a point, and quite a few plaintiffs won judgements against their lenders.
These features, therefore, created problems for lenders as well as borrowers. The CFPB attempted to address these issues by forbidding or curtailing certain features that they considered risky.
Qualified Mortgage Rules
Four basic rules were developed for lenders.
Certain “Risky” Terms Forbidden
- Interest-only loans, where for a defined period of time a borrower could pay only the accrued interest on a loan, rather than a fully amortized payment. (Risky because at the end of the interest-only period, the payment would jump.)
- Negative amortization, where your minimum payment is less than the accrued interest. The balance owed on these loans can increase over time, and the payments can jump.
- Balloon payments, where you must make a very large payment at the end of the term to pay off the loan
- Loans amortized for more than 30 years
Maximum Debt-to-Income Ratio
This is known as the “ability to repay” rule. A lender cannot allow your total monthly obligations for housing plus all other debt to be more than 43 percent of your gross income. The lender is also required to verify and document your income, and document that it is stable, predictable and likely to continue for at least five years. (Therefore, stated income loans cannot be qualified mortgages.)
No Excess Points and Fees
The intent of this requirement is to prevent lenders from quoting you one price and then charging you more when you go to close your loan.
Legal Protection for Lenders
If a lender follows all of the above rules, it is presumed to have made a safe loan. If the borrower later claims that the lender should not have made the loan, the lawsuit is summarily dismissed. This is known as the Safe Harbor Rule.
Simply put, a qualified mortgage is one that meets the rules outlined above, and one where the lender is protected from lawsuits that claim that it should have known the borrower would not be able to pay the loan back. Note that these rules apply only to loans on personal residences. Investors are presumed to be knowledgeable enough to protect themselves.
What is a Non-Qualified Mortgage?
Let’s start by saying that a non-qualified mortgage (or non-QM) is not a subprime loan. It is a mortgage that doesn’t conform to the qualified mortgage rules. It still may require excellent credit and carry very competitive interest rates that are only slightly higher than those for qualified mortgages.
For example, there is still demand for interest-only loans, as they allow for lower payments in the early years of a loan.
Some lenders offer loans for self-employed borrowers, whose income is documented with bank statements rather than with traditional documents, such as tax returns. Others now offer true stated income loans, where no income documentation is required at all.
Since a lender must document that your income is stable, predictable and likely to continue, QM lenders cannot use income from stock grants or options. (Since the market price of the stock can vary, income from stocks is not predictable.) Some non-QM lenders therefore offer mortgages where the option income can be used to qualify.
Why Would You Want a Non-Qualified Mortgage?
Because a lender has less risk if it makes a qualified mortgage, it can charge lower interest rates and fees than it would for a non-qualified mortgage. You would only want a non-qualified mortgage, therefore, if you needed one because you could not document your income, or wanted an interest-only loan.
How Do You Get a Qualified Mortgage?
Since you want the best interest rate possible, you want to make sure you end up with a qualified mortgage. Since the lender is protected from lawsuits, it does too. If you can fully document your income and don’t need interest-only payments, you’ll almost always end up getting a qualified mortgage.