How does a non-conforming loan work?

Many mortgage lenders offer non-conforming loans, and some even specialize in them. They work in much the same way as a conforming loan in that they allow you to borrow money to buy a home. The difference: They’re not able to be purchased by Fannie Mae and Freddie Mac, which buy mortgages from lenders and package them for investors. The capital derived from these sales helps lenders continue to offer more mortgages.

For this reason, lenders tend toward conforming versus non-conforming loans, because conforming loans can be pooled easily into investment bundles and sold on this secondary mortgage market. Because they can’t sell non-conforming loans to the GSEs, lenders often keep these on their books, which requires more work to underwrite.

For you as the borrower, the lack of GSE backing isn’t necessarily cause for concern; there are some non-conforming loans that are backed by other government agencies instead of the GSEs. The non-conforming loans without backing, however, might present risks.

Types of non-conforming loans

Government-insured loans

A government-insured mortgage is one backed by either the Federal Housing Administration (FHA loans), the U.S. Department of Veterans Affairs (VA loans) or U.S. Department of Agriculture (USDA loans). These aren’t eligible to be bought by Fannie Mae or Freddie Mac, but they are backed by their respective agencies, so you can rest assured they’re safe products. Here’s an overview:

• FHA loans: FHA loans allow you to borrow money for a home purchase with a credit score as low as 580 (or 500 if you have a bigger down payment) and a down payment of just 3.5 percent. Unlike some other non-conforming loans, however, you’ll need to pay mortgage insurance premiums with your FHA loan.
• VA loans: VA loans are mortgages for service members, veterans and surviving spouses. If you’re eligible, you can buy a home with a VA loan for no money down and no requirement to pay mortgage insurance. (Instead, you’ll pay a one-time funding fee.)
• USDA loans: USDA loans are for those buying a home in certain rural areas designated by the government. Like VA loans, you can get a USDA loan with no money down, but you’ll be required to pay some fees.

Jumbo loans

A jumbo loan is one of the most common types of non-conforming loans, though not every lender offers them. These loans are for borrowers in need of a bigger mortgage than what’s allowed with a conforming loan. In most areas in 2023, that means a mortgage for more than $726,200 ($1,089,300 in higher-priced markets). In many places where home prices have risen substantially, a jumbo loan might be the only option for some borrowers.

While jumbo loans (those exceeding conforming loan limits) tended to have higher interest rates than conforming loans, jumbo rates have been much lower this year. They can be more difficult to qualify for, however. You might need to put more money down upfront, for example, have a better credit score (typically 700 or higher) and additional assets in the bank.

Hard money loan

A hard money loan is a non-conforming loan providing a borrower with short-term funding. They’re often sought by real estate investors who need money to flip a property but might not have the credit or financials on paper to qualify for a more traditional home renovation loan. Hard money loans have higher interest rates and shorter terms, so they’re more expensive and carry more risk.

Interest-only loan

Interest-only loans are non-conforming because they aren’t structured like conforming loans, which require you to repay both principal and interest as the loan amortizes over time. Rather, with an interest-only loan, you’ll pay just interest initially for a time, such as 10 years, after which you’ll repay both interest and principal, sometimes in one lump sum known as a balloon payment. This payment might be unmanageable for some borrowers.

Who is a non-conforming loan best for?

A non-conforming mortgage is best for those who need a larger loan or otherwise don’t qualify for a conforming loan or conventional loan. This might include borrowers who have a lower credit score or limited or no down payment savings, or those who are real estate investors or self-employed. It might also be the only option for borrowers who need a bigger loan due to high home prices.