What is Non-Conforming Loan?
Non-Conforming Loan is a loan given to the borrower who do not pass the traditional guidelines of loan issuance and have high loan to value ratio, lower credit quality, or don’t offer a collateral. Such loans are risky as they don’t meet the guidelines of government agencies, hence they can’t be re-sold by lenders to agencies like Fannie MaeFannie MaeFannie Mae, i.e., Federal National Mortgage Association is a United States government-sponsored enterprise (GSE) which was founded in the year 1938 by congress to boost the secondary mortgage market during the great depression which involves financing for the mortgage lenders thereby providing access to affordable mortgage financing in all the markets at all times. or Freddie Mac. Due to the riskiness, the interest rate charged on this loan is higher and it is advisable to use all traditional methods before applying for this loan.
How does Non-Conforming Loan Work?
If a borrower requires a loan using the traditional method, then he approaches lenders who are ready to give loans without being stringent on all the factors. The lenders are taking a risk as the loans are Non-Conforming, which means they can’t sell it to government agencies to free up their cash to issue further loans at the current rate. So the lenders will be losing liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. and taking risks. For this reason, they demand a higher interest rate from borrowers. Borrowers are also benefited as they are getting loans without meeting all the criteria.
Non-Conforming Loan Types
- Commercial Non-Conforming Loans: These are loans taken to fund commercial projects. Secured properties are kept as collateral, and loans are issued based on them.
- Residential Non-Conforming Loans: The interest rate charged is much higher than normal, confirming residential loans. The activities in the market are mostly regulated, and the limit is set regarding the maximum loan that can be issued.
Mr. X is planning to buy a property worth $400,000. It is a general guideline that the down payment will have to be 10% of the property value. So 10% of $400,000 is supposed to be $40,000. Suppose Mr. X doesn’t have $40,000. So he will not be able to get the loan in the traditional way. The mortgage rate in the traditional market is 4%, and for Non-Conforming loans, lenders are charging 7%.
Even though Mr. X had the credit quality, he doesn’t have the required down payment and therefore, he will have to opt for a non-conforming loan.
Selecting Non-Conforming Lenders
- What is the best rate that the Non-Controlling lender is offering? That rate should be tallied with other lenders, and the lowest should be chosen?
- Terms should be predefined. So the borrower must check with the lender personally regarding the terms and document the terms before taking the loan. Best terms should be accepted.
- A lender with experience should be chosen, as the lender is in the market for a long time, so the rates and terms can be trusted. New lenders are doubtful as the main motive could be to confiscate the property.
- Reviews should be read from earlier borrowers regarding a lender before entering into the deal. Past borrowers will share the real hand experience, which will help to portray a real picture.
Difference Between Non-Conforming and Conforming Loan
Confirming loans are loans that meet the guidelines of Government Sponsored Entities. These entities, after a thorough analysis of the credit market, have prepared a guideline for loans that could be sold in the market. When a loan meets all the drafted guidelines, then that loan is considered to be secured and is called a Conforming loan. On the other hand, Non-Conforming loans don’t follow strict guidelines and are difficult to be resold to agencies for structuring them and sold to institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples..
- The down-payment requirement is less. So unlike conforming loans where the borrowers will have to abide by strict down-payment requirements, the Non-Conforming loans can be taken with the less down-payment requirement.
- The approval process is short, so it can be taken quickly.
- Less creditworthy borrowers who have plans to expand the business and is facing difficulty to raise loan otherwise can opt this method.
Non-Conforming loans can be useful for borrowers who lack all the required factors to get loans approved by government agencies. So this helps in the running of the credit market smoothly. Such loans are not defaults, but they are a bit risky and should be given to creditworthy borrowers.
This has been a guide to What is Non-Conforming Loan & its Definition. Here we discuss its types and how it works along with examples and benefits. You can learn more about from the following finance articles –