Nonconforming Mortgage

What Is a Nonconforming Mortgage?

A nonconforming mortgage is a mortgage that does not meet the guidelines of government-sponsored enterprises (GSE) such as Fannie Mae and Freddie Mac and, therefore, cannot be sold to them. GSE guidelines consist of a maximum loan amount, suitable properties, down payment requirements, and credit requirements, among other factors.

A nonconforming mortgage may be contrasted with a conforming mortgage.

Understanding Nonconforming Mortgages

Nonconforming mortgages are not bad loans in the sense that they are risky or overly complex. Financial institutions dislike them because they do not conform to GSE guidelines and, as a result, are harder to sell. For this reason, banks will usually command a higher interest rate on a nonconforming loan. 

Although private banks initially write most mortgages, they often end up in the portfolios of Fannie Mae and Freddie Mac. These two GSEs buy loans from banks and then package them into mortgage-backed securities (MBS) which sell on the secondary market. An MBS is a type of asset-backed security (ABS) secured by a collection of mortgages that originated from a regulated and authorized financial institution. While there are private financial companies who will buy, package, and resell an MBS, Fannie and Freddie are the two largest purchasers.

Banks use the money from the sales of mortgages to invest in offering new loans, at the current interest rate. But Fannie Mae and Freddie Mac can’t buy just any mortgage product. The two GSEs have federal rules limits to buying loans that are deemed relatively risk-free. These loans are conforming mortgages, and banks like them precisely because they will readily sell.

By contrast, mortgages that Fannie Mae and Freddie Mac cannot buy are inherently riskier for banks to write. These difficult-to-sell loans must either stay in the bank’s portfolio or be sold to entities specializing in the secondary market for nonconforming loans.

Types of Nonconforming Mortgages

There are various borrower situations and types of loans that Fannie and Freddie deem as nonconforming. 

The most common nonconforming mortgage is what’s often called a jumbo mortgage — loans written for an amount more substantial than the Fannie Mae and Freddie Mac limits. In 2021, that limit in most U.S. counties is $548,250, but in some high-cost areas, such as New York City or San Francisco, it can be as high as $822,375.

Mortgages don’t have to be jumbo to be nonconforming. A low down payment can trigger nonconforming status, too. The threshold varies but could be 10-percent on a conventional mortgage or as little as 3-percent on a Federal Housing Administration (FHA) loan.

Also, a factor is the buyer’s debt-to-income ratio (DTI), which typically needs to be lower than 42-percent to qualify as a conforming loan. A credit score above 630-650 is usually required as well.

The type of property can also determine if a mortgage is nonconforming. For example, buyers of condos often get tripped up when they learn their dream vacation unit is nonconforming because the complex is considered non-warrantable. That includes condo associations where a single entity, such as the developer, owns more than 10-percent of the units. Other pitfalls include if a majority of the units are not owner-occupied, if more than 25-percent of the square footage is commercial, or if the homeowners association (HOA) is in litigation.