Before the coronavirus pandemic, the housing market offered plenty of reasons for optimism. The U.S. unemployment rate and mortgage rates were at historic lows. Consumer confidence was strong. The National Association of Realtors and the Mortgage Bankers Association projected continued growth in home sales and origination volumes.
Yet the picture was far from perfect. Lending requirements for government-insured and conforming loans have remained relatively strict since the Great Recession. Rising home prices were making homeowner-ship more difficult, especially for younger buyers. With next year’s expiration of the qualified mortgage patch, there’s uncertainty about whether the government-sponsored enterprises (GSEs) will allow higher debt-to-income ratios for conforming loans.
These obstacles aren’t helping the growing number of potential homebuyers who may have excellent income and good financial habits, yet do not fit the profile of the average mortgage borrower. Thankfully, nonqualified mortgages (non-QM) have helped fill this gap. These loans do not conform to the standards set by the Consumer Financial Protection Bureau, but they are a valuable option for both borrowers and originators.
Underwriting non-QM loans isn’t the same as underwriting other types of mortgages. For the non-QM market to continue to grow, sound underwriting will be key.
Although the non-QM market has not taken off as quickly as some have hoped, it has grown significantly. Residential mortgage-backed security issuances of non-QM loans have grown from three deals totaling $570 million in 2016 to 57 deals worth about $23 billion in 2019, according to Moody’s. That’s still only a sliver of the overall origination market, but the demand for non-QM loans is likely to persist in the coming year as investor interest in the real estate market increases and the number of self-employed workers continues to grow.
In fact, 17% of tax filers reported self-employment income in 2017, which was the highest share in the 60 years the IRS has tracked that data, according to a recent New York Times article. But there are many other types of non-QM borrowers.
High-income earners with significant assets, in addition to small-business owners and entrepreneurs, make up another large portion of non-QM borrowers. Non-QM loans also are popular with borrowers who have blemishes on their credit histories or high student-loan debt and are looking for opportunities to improve their credit. As a result, the types of non-QM loans have expanded tremendously, with options available for almost every imaginable borrower — even those without a Social Security number or FICO score.
Although Moody’s has painted a picture of a strong non-QM market, the ratings agency also voiced concern over non-QM underwriting standards and the potential for defaults. It’s a fair point, even though many non-QM products are quality loans and are nothing like the subprime loans that nearly took down the U.S. economy more than a decade ago. This means that underwriting non-QM loans requires a different approach, especially if the goal is to expand credit to atypical borrowers.
A non-QM loan is one that doesn’t meet the definition of a qualified mortgage. This doesn’t mean that non-QM loans are similar to Alt-A or subprime loans. In fact, typical non-QM loans are more representative of prime, nonconforming jumbo loans, as they require the borrower’s income to be verified as well as good to outstanding credit.
One way for originators to push a borrower’s acceptable debt-to-income (DTI) ratio higher and still create risk-averse loans is by requiring a lower loan-to-value (LTV) ratio and other offsetting factors such as significant cash reserves. When these safeguards are present, DTI is usually not an issue and the result is a safe loan.
A popular method of underwriting non-QM loans for self-employed borrowers is by using the borrower’s profit-and-loss (P&L) statements. To qualify for financing, P&L statements can be prepared by a licensed tax professional or public accountant. Some non-QM financing allows borrowers to use income documented on their 1099 forms, which is then matched with IRS transcripts for verification.
Through a combination of automated underwriting and human discretion, underwriters can push the limits on DTI and standard income requirements even higher while still creating non-QM loans that are less risky. The secret is to combine automated underwriting with human experts who have experience working with atypical borrowers and an understanding of the different ways these borrowers can demonstrate their ability to pay.
To originate loans outside the typical credit box and also mitigate risk, originators need sound operational controls. This begins with establishing quality underwriting processes that are aided by technology.
Nonagency automated underwriting systems have proven quite effective for originating non-QM loans, as they bring clarity to the process and put everyone on the same page. From the perspective of a mortgage broker or loan officer, the ability to take advantage of non-QM opportunities will require the help of a partner with access to these unique underwriting tools as well as non-QM loan-pricing technologies, which enable originators to receive real-time product guidelines and pricing.
Yet lenders will still require the input of human experts. In fact, staff expertise accounts for a significant share of the underwriting process even when automated underwriting tools are present. The reason is that there is no single non-QM borrower “type.” If a borrower is lacking the necessary requirements in any particular area, it takes human experts to determine which compensating factors will be most meaningful for proving an ability to repay and for approving the loan.
The bottom line is that non-QM loans should be part of every lender’s or broker’s business. Assuming they are underwritten correctly, they are among the most sound and highest-quality loans being originated today. Just as important, they are filling a huge and growing market need.
At the end of the day, the goal of every mortgage professional is to have a financing option for every client. By adding properly underwritten non-QM loans to their product mix, they’ll be more likely to do so — and they will look like superheroes to those who may have been turned down before.