Non-Conforming Loan

Updated on March 19, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Non-Conforming Loan?

A non-conforming loan is a loan given to the borrower who does not pass the standard guidelines of loan issuance and has a high loan to value ratio, lower credit quality, or does not offer collateral. Such loans are risky as they do not meet the guidelines of government agencies. Hence, lenders cannot resell them to agencies like Fannie Mae or Freddie Mac. Due to the riskiness, the interest rate charged on this loan is higher. Therefore, it is advisable to use all traditional methods before applying for this loan.

Key Takeaways

  • Non-conforming loans are provided to borrowers who do not meet the standard guidelines for loan issuance. These loans may have a high loan-to-value ratio, lower credit quality, or lack collateral. They are considered risky and cannot be resold to government agencies like Fannie Mae or Freddie Mac. 
  • Due to the higher risk, non-conforming loans have higher interest rates. It is recommended to exhaust traditional loan options before considering these loans. 
  • Non-conforming loans can be categorized into commercial non-conforming and residential non-conforming loans. 
  • Non-conforming loans adhere to strict guidelines, making it challenging to structure and sell them to institutional investors or agencies. 

How does Non-Conforming Loan Work?

If a borrower requires a loan using the traditional method, he approaches lenders ready to give loans without being stringent on all the factors. However, the lenders are taking a risk as the loans are non-conforming, which means they cannot sell them to government agencies to free up their cash to issue further loans at the current rate. So, the lenders will be losing liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more and taking risks. For this reason, they demand a higher interest rate from borrowers. Borrowers benefit as they get loans without meeting all the criteria.

Non-Conforming-Loan

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Non-Conforming Loan Types

  1. 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.
  2. 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 one can issue.

Examples

Mr. X is planning to buy a property worth $400,000. A general guideline is that the down payment must be 10% of the property value. So, 10% of $400,000 is supposed to be $40,000. Suppose Mr. X does not have $40,000. So, he will not traditionally get a loan. The mortgage rate in the traditional market is 4%, and for non-conforming loans, lenders charge 7%.

Even though Mr. X had the credit quality, he does not have the required down paymentDown PaymentDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. read more. Therefore, he may have to opt for a non-conforming loan.

Selecting Non-Conforming Lenders

  • What is the best rate that the non-controlling lender is offering? Then, one should tally that rate with other lenders, choosing the lowest.
  • Terms should be predefined. So, the borrower must check with the lender personally regarding the terms and document the terms before taking the loan. But, of course, one should accept the best conditions.
  • One must choose a lender with experience, as the lender has been in the market for a long time to trust the rates and terms. New lenders are doubtful as the main motive could be confiscating the property.
  • Before entering into the deal, one should read reviews from earlier borrowers regarding a lender. Past borrowers will share the real hand experience, which will help to portray a real picture.

Difference Between Non-Conforming and Conforming Loans

Conforming loans are loans that meet the guidelines of government-sponsored entities. After a thorough analysis of the credit market, these entities have prepared a policy for loans that one could sell in the market. When a loan meets all the drafted guidelines, that loan is considered secured and is called a conforming loan. On the other hand, non-conforming loans follow strict guidelines and are difficult to resell to agencies for structuring and selling them 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.read more.

Benefits

  • The down-payment requirement is less. So unlike conforming loans where the borrowers will have to abide by strict down-payment requirements, one can take non-conforming loans with less down-payment need.
  • The approval process is short so one can take it quickly.
  • Less creditworthy borrowers who plan to expand the business and face difficulty raising loans can otherwise opt for this method.

Conclusion

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 risky and should be given to creditworthy borrowers.

Frequently Asked Questions (FAQs)

1. Is a non-conforming loan a conventional loan? 

No, a non-conforming loan is not a conventional loan. Conventional loans generally conform to the guidelines set by government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. Non-conforming loans, on the other hand, do not meet these guidelines and may have different criteria, such as higher loan amounts or unique borrower qualifications.

2. Is a jumbo loan considered non-conforming? 

Yes, a jumbo loan is considered a non-conforming loan. Jumbo loans exceed the loan limits set by Fannie Mae and Freddie Mac for conforming loans. These loans are typically used to finance higher-priced properties and require different underwriting standards and larger down payments than conforming loans.

3. Is FHA a non-conforming loan? 

FHA (Federal Housing Administration) loans are not considered non-conforming loans. FHA loans are government-backed loans that the FHA insures. They have specific guidelines and requirements, including loan limits, borrower qualifications, and down payment requirements. Therefore, FHA loans are considered a type of government-insured loan rather than non-conforming loans.

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