It can be easier to qualify for a mortgage if you have a steady W-2 income, a strong credit score and a straightforward tax return. But not every mortgage applicant fits that mold. If you’re self-employed, have fluctuating income or have issues with your credit history, you may have a harder time qualifying for a mortgage. That is where nonqualified mortgages, called non-QM loans, can help.
Here, we’ll discuss how non-QM loans work, for whom they may be right, and the benefits and drawbacks of signing one.
Key Takeaways:
- Qualified mortgages follow strict rules designed to ensure that borrowers can reasonably repay their loans, whereas non-QM loans offer more flexible underwriting standards.
- Non-QM loans may be useful to self-employed borrowers, investors and people with nontraditional income.
- Non-QM loans may have easier qualification requirements but typically come with higher interest rates and larger down payments.
What Is A Qualified Mortgage?
A qualified mortgage is a home loan that meets standards established by the Consumer Financial Protection Bureau (CFPB) under the Ability-to-Repay (ATR) rule. The ATR rule requires lenders to make a reasonable, good-faith determination that a borrower can repay the loan.
A mortgage generally must meet several requirements to be considered a qualified mortgage:
- No negative amortization
- A term of 30 years or less
- No balloon or interest-only payments (smaller lenders may be an exception under specific conditions)
- Reasonable upfront fees (generally, fees that can’t exceed 3% of the loan amount for moderate-sized or larger loans)
Qualified mortgages also require lenders to verify each borrower’s income, assets and debts. That includes reviewing each borrower’s debt-to-income ratio, or DTI, which measures how much of a person’s gross income goes toward debt payments.
The CFPB later uses a pricing-based approach to assess qualified mortgages, and a loan now qualifies as a qualified mortgage if its annual percentage rate doesn’t exceed the average prime offer rate for a similar loan by more than 2.25 percentage points for most loans; however, lower loan amounts may account for higher percentage point increases and still be considered “qualifying.”
While the hard regulatory cap on DTI has been replaced by a pricing approach, qualified mortgage lenders still carefully review DTI and tend to favor DTIs that are not above 43%. But lenders will sometimes approve a loan for a borrower with a higher DTI if they have strong credit and ample funds to purchase the home.
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What Is A Non-QM Loan?
A nonqualified mortgage, or non-QM loan, is a mortgage that does not meet the CFPB’s qualified mortgage standards. That doesn’t mean there aren’t standards at all, though. Lenders want to get repaid when they issue mortgages, so they still verify applicants’ financials before loaning out large sums of money. Rather, it’s that non-QM loans use more flexible underwriting guidelines than traditional qualified mortgages.
Non-QM loans may be an option for borrowers whose income or financial situations are difficult to document using conventional methods, including:
- Self-employed workers
- Freelancers and gig workers
- Real estate investors
- Foreign nationals
- Retirees with substantial assets
For example, a self-employed business owner may write off large expenses on their tax returns, making their taxable income seem too low for conventional mortgage underwriting. A non-QM lender may instead evaluate bank deposits or the overall cash flow of the business to make a decision.
In addition to greater flexibility in income verification, non-QM loans may also allow higher DTIs and lower credit scores. But that flexibility carries more risk for lenders. These loans are riskier for lenders because they lose the protection from ATR lawsuits that qualified mortgages provide. For this reason, non-QM loans often come with higher interest rates and stricter down payment requirements than qualified mortgages.
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QM Vs. Non-QM Loans: A Comparison
Qualified mortgages and non-QM loans differ significantly in a number of key areas.
Interest Rates
Qualified mortgages generally offer lower interest rates because lenders commonly take on less risk. Non-QM loans generally carry higher rates due to the greater risk lenders take on.
Down Payment Requirements
Qualified mortgages may allow down payments as low as 3% for some conventional loans. Non-QM lenders often require larger down payments. The exact down payment depends on the lender, but it’s common for lenders to require a larger down payment.
Documentation Standards
QM loans typically require:
- W-2 forms
- Pay stubs
- Tax returns
- Proof of employment
Non-QM loans may instead use:
- Bank statements
- Asset statements
- Rental income
- Business cash flow
- Profit-and-loss statements
Qualifying Criteria
Qualified mortgages follow strict CFPB guidelines. Non-QM lenders have more flexibility in evaluating:
- Credit score
- DTI
- Employment history
- Income consistency
Lender Availability
Most mortgage lenders offer qualified mortgages. Non-QM loans may be harder to find, and not every lender offers them.
Here’s a summary of the differences between qualified and non-QM loans.
| Feature | Qualified Mortgage | Non-QM Loan |
|---|---|---|
| CFPB Compliance | Strict | Flexible |
| Interest Rates | Lower | Higher |
| Income Verification | Traditional | Flexible/alternative means |
| Down Payment | Can be as low as 3% on conventional loans | Higher and may vary per lender |
| DTI Requirements | Stricter (though some flexibility) | More flexible |
| Borrowers Who Can Benefit | Buyers with traditional employment | Self-employed workers, freelancers, real estate investors |
| Lender Availability | Widely available | More limited availability |
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Pros And Cons Of Qualified Mortgages
Qualified mortgages offer several important advantages for borrowers:
- Lower interest rates: Lenders typically offer more competitive rates, which can result in lower monthly payments.
- Stronger borrower protections: Restrictions on risky loan features help borrowers avoid payment shock and predatory lending practices.
- Lower down payment options: Some qualified mortgages allow borrowers to make very low down payments.
Qualified mortgages also have these drawbacks:
- Stricter qualification standards: Borrowers with a high DTI or low credit score may struggle to qualify, as may workers with less traditional incomes.
- Less flexibility: Alternative income documentation is often difficult to use with qualified mortgage underwriting.
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Pros And Cons Of Non-QM Loans
Non-QM loans come with certain benefits:
- Flexible underwriting standards: Lenders may accept nontraditional income verification methods such as bank statements.
- Credit score flexibility: Borrowers with lower credit scores may still be able to qualify.
- More wiggle room on DTI: Borrowers with higher DTIs may still qualify.
Non-QM loans also have these drawbacks:
- Higher interest rates: Lenders usually charge higher interest to help offset their risk.
- Larger down payment requirements: Many lenders require more money at closing.
- Limited lender choices: Fewer lenders offer non-QM loans.
Non-QM Loan Types
There are different types of non-QM loans available to borrowers.
Bank Statement Loans
Bank statement loans allow borrowers to qualify using bank deposits rather than tax returns or W-2s. If you show a lower income on your taxes but have substantial cash reserves, you may qualify.
DSCR Loans
Debt-service coverage ratio loans are popular among real estate investors. Instead of evaluating the borrower’s personal income, lenders typically analyze whether the property’s rental income equals or exceeds the mortgage payments.
Balloon Mortgages
A balloon mortgage is a mortgage that typically comes with low initial payments, often interest only, followed by a single large payment to pay off the remaining balance. These loans tend to be risky for everyday home buyers but may be suitable for real estate investors or buyers expecting a large windfall.
Interest-Only Mortgages
An interest-only mortgage lets borrowers cover just the interest portion of the loan for a preset number of years. After that, the balance begins to amortize and monthly payments increase.
Asset-Based Loans
Asset-based loans allow borrowers to qualify using assets rather than regular employment income. The types of assets that help you qualify could include:
- Savings accounts
- Investments
- Retirement portfolio assets
How To Shop For A Non-QM Loan
Not all lenders offer non-QM loans. Before you begin shopping for one, you may want to review your financial profile to see if you can get a qualified mortgage.
You can search for non-QM lenders online or enlist the help of a mortgage broker to find one. When comparing non-QM lenders, consider factors such as:
- Interest rates
- Down payment requirements
- Minimum credit score requirements
- Income documentation options
- Closing costs and fees
FAQ
The Bottom Line On Non-QM Loans
Qualified mortgages tend to be more affordable for borrowers and offer certain protections. But if you don’t qualify for one, you can look at a non-QM loan instead.
While non-QM loans often come with higher rates and stricter down payment requirements, they can open the door to homeownership for different types of buyers. But if you’re going to sign one of these loans, it’s crucial that you understand the terms and are confident you’re in a position to keep up with your ongoing payments.
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Maurie Backman
Maurie Backman has more than a decade of experience covering personal finance topics that include mortgages, loans, retirement, Social Security, and investing. Prior to becoming a full-time writer, she worked in the financial industry as well as in product design and marketing. Maurie holds a bachelor's degree from Binghamton University, where she studied creative writing and finance. She was happy to combine her two areas of study into a career that allows her to educate consumers on a host of financial topics.
