What Are Non-Conforming Loans and How Do They Work?

As you begin your homebuying journey, your first concern is probably, “How am I going to finance my house?”

If you’ve missed a couple of credit card payments and your credit score is still recovering, or you once filed for bankruptcy, there are still loan options that will allow you to achieve your goal of homeownership.

While your credit history does impact which loan programs, you’ll be likely to qualify for, past issues on your credit report don’t necessarily mean that you won’t be able to qualify for a loan.

Your loan officer should help you assess your personal financial situation and find the best loan option for you. One of those options might be a non-conforming loan.

We will dive into learning what a non-conforming loan is, how they work, and whether one may be the best fit for you.

What is a Non-Conforming Loan?

In simplest terms, a non-conforming loan is a loan that does not meet the standards for Fannie Mae and Freddie Mac to purchase. Fannie Mae and Freddie Mac are two separate government-sponsored enterprises (GSEs) that play an important role in the nation’s housing finance system.

These agencies invest in mortgage loans by purchasing them from lenders.

There are two main reasons why a loan would be considered non-conforming: either the mortgage does not meet the Federal Housing Finance Agency (FHFA) requirements, or it is larger than the year’s conforming loan limits.

The FHFA is in charge of setting the standards for the loans that Fannie Mae and Freddie Mac are able to buy. In order to qualify for a conforming loan, a buyer usually must have:

• A credit score of at least 620
• A debt-to-income ratio (DTI) lower than 45%
• A down payment of at least 3%
• A stable record of employment and income going back at least two years.  

How Do Non-Conforming Loans Work?

Non-conforming loans work almost the same as conforming loans do. Your loan officer will help guide you through the application process and you will also be asked to provide some documents, including proof of income. Your lender will also run a credit check. Once your application has been approved and the property has been appraised, you will be cleared to close.

Non-conforming loans are riskier for the lender because a GSE won’t purchase the loan from the lender. This means that if the buyer defaults on the loan, the lender must directly absorb the loss. As a result, non-conforming loans may have higher interest rates or fees than other loan options.

Types of Non-Conforming Loans

There are a few different types of non-conforming loans. The two most common types are government-backed loans and jumbo loans.

Government-Backed Loans

Government-backed loans are insured by the federal government to help cover any losses if a loan is defaulted on.

VA Loans are only available for qualifying members of the armed forces, veterans, and their spouses. These loans are insured through the Department of Veterans Affairs. In order to qualify, you must meet the service requirements or be the spouse of a service member that lost their life in the line of duty or as a result of a disability. One of the reasons that VA loans are seen as one of the top benefits for service members is that they allow you to buy a house with no down payment.

FHA Loans are insured by the Federal Housing Administration. They allow you to make a down payment as low as 3.5% with a credit score of at least 580. FHA loans were created to benefit low to medium-income homebuyers.

USDA Loans are an option if your prospective house is in an area that is deemed sufficiently rural by the United States Department of Agriculture. In order to be eligible, you cannot earn more than 115% of the county’s median income and the property cannot be a working farm.

Jumbo Loans

Every year, the FHFA sets a limit on the largest loan amount that Fannie Mae and Freddie Mac are able to purchase. This is known as the conforming loan limit. If a loan amount exceeds the conforming loan limit, it is considered a jumbo loan.

Because jumbo loans are larger, they have much stricter requirements to be able to qualify. They typically require that your DTI ratio is low and higher credit scores. Each individual lender sets their own requirements to qualify, so you would be well off comparing your options to find the one with the highest loan limit.

Should You Consider a Non-Conforming Loan?

In general, non-conforming loans are good options for borrowers who don’t qualify for a conventional loan and are looking for a way to finance a large purchase, such as a high-end home, or who have unique financial circumstances that make it difficult for them to meet the standard loan requirements. As you now know, if your loan officer recommends exploring non-conventional loan options, it does not necessarily mean that there is cause for concern.

We encourage you to reach out to one of our loan officers, who will work with you to assess your situation and give you the resources to make an educated decision. Knowing and understanding your options will help you make the best financial decision for you. Get started on your homebuying journey today!