What is a Qualified Mortgage?

Article Summary

A qualified mortgage is a mortgage that meets specific requirements for secondary market trading and lender protection under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The goal of these requirements is to make mortgages safer, easier to understand, and put a cap on the fees lenders can charge. However, that doesn’t mean non-qualified mortgages are necessarily a bad deal.

The Consumer Finance Protection Bureau created a new class of mortgages called “Qualified Mortgages” (also known as QMs) in 2014. The rules provide homeowners and borrowers with new rights and protections. They also incentivized the offering of high-quality mortgage loans in the primary and secondary mortgage markets.

In other words, they require lenders to take steps to ensure borrowers have the ability to make their mortgage payments. These changes were part of Dodd-Frank Wall Street Reform and Consumer Protection Act. Lenders who wish to offer qualified mortgages must employ good faith effort to ascertain that you can repay the mortgage before taking it out. This is the “ability-to-repay” rule.

What is a qualified mortgage?

Simply put, a qualified mortgage is a home loan that meets specific federal guidelines, which prevent the issuing of loans to borrowers who can’t afford them. Qualified mortgages are s a category of loans with more stable features that make it less likely for a borrower to receive a mortgage they can’t afford to pay.

These requirements include meeting the “ability-to-pay” rule and not offering balloon mortgages (interest-only) or negative amortization loans. Negative amortization loans are those where the principal grows over time even when you are making regular and on-time payments. The comparison tool below allows you to compare the terms of leading mortgage lenders.

How do qualified mortgages work

A qualified mortgage requires the lender to meet “ability-to-repay” rules. Lenders will request and document your assets, credit history, income, monthly expenses, credit score, debt-to-income ratio, and employment history to ensure you have the ability to repay the loan you’re taking out.

Both borrowers and lenders must meet certain requirements for a mortgage to qualify. The main requirements are:

  • The lender hasn’t charged over 3% in origination fees and points
  • Mortgage payments don’t exceed 43% of the borrower’s monthly income (debt-to-income ratio)
  • The loan does not include risky terms, such as interest-only payments or negative amortization.

Qualified mortgage regulations also protect lenders

The QM rules also protect lenders. The “safe harbor” provisions safeguard lenders from lawsuits filed by distressed borrowers claiming lenders gave them a loan amount they had no reason to believe they’d repay.

They also give incentives to lenders wishing to sell loans in the secondary market because qualified mortgages are more attractive to underwriters in structured product deals.

Lenders find it easier to resell qualified mortgages to government entities like Freddie Mac and Fannie Mae. They purchase these loans to free up capital for financial institutions to provide additional loans. However, only specific qualified mortgages are qualified for sale in the secondary market.

What’s a non-qualified mortgage?

A non-qualified mortgage, also known as non-QM, is a home loan type that doesn’t meet the standards required for a qualified mortgage.

Non-qualified mortgages don’t have to conform to the same underwriting standards, such as the debt-to-income limit. Therefore, they can be more flexible with eligibility and provide new borrowers with more mortgage program options.

It’s important to note that non-qualified loans vary from lender to lender.

There are three main reasons borrowers will choose a non-qualified mortgage. These include:

  • Higher DTI ratios of over 43%
  • Interest-only loans
  • Limited documentation

Does it matter if a loan is a qualified mortgage?

Qualified mortgage loans provide valuable protections to both lenders and borrowers. This doesn’t mean non-qualified mortgages are necessarily low-quality loans. According to CoreLogic, the average loan-to-value ratio for QM loans was 80% compared to 79% for non-qualified mortgage loans.

Qualified mortgages can be backed, guaranteed, or insured by VA, FHA, Freddie Mac, and Fannie Mae. This makes them safer for investors buying mortgage-backed investments.

A qualified mortgage helps ensure borrowers don’t overpay in fees and points and reduces the risk of getting a mortgage you can’t approve. However, if you have unreliable income streams or high DTI ratios, a non-qualified mortgage may be your only option.

What are the requirements for a Qualified Mortgage?

As outlined by the CFPB, qualified mortgages must meet the following four requirements:

ATR rule

This is the ability-to-repay rule. Lenders must verify that the borrower can make the monthly payment by documenting assets, employment, monthly expenses, credit history, and income.

This rule doesn’t include the low-initial rate mortgages known as teaser rates that dramatically increase towards the introductory period.

Restrictions on risky loan features

Some mortgage loan types are not eligible for QM status. These include:

  • Loans with reduced interest-only payments for a part of the repayment loan term during which borrowers can accrue no equity in the property.
  • Loans with a large final payment, commonly known as a balloon payment, towards the end of the repayment period.
  • Negative-amortization loans. These are loans where the principal and interest payments owed on the mortgage rise over the loan term of repayment.
  • Mortgages with repayment terms exceeding 30 years.

Income-based restrictions

Lenders giving out QMs must confirm that the monthly payment doesn’t result in a household debt-to-income ratio of over 43%.

The debt-to-income (DTI) limit is calculated by dividing your total monthly debt payments (mortgages, credit cards, auto, and credit cards) by the monthly pretax income of the borrower.

This restriction is designed to protect homebuyers from borrowing more than they can afford.

Limits on points and fees

A qualified mortgage for over $100,000 cannot require points or other fees surpassing 3% of the loan amount.

Consumer protections provided by qualified mortgages

The CFPB rules provide protections for borrowers who fall behind in their mortgage payments. Here is a summary of the rules lender must follow.

  1. Mortgage servicers have to call or contact most borrowers by the time they are 36 days late on their mortgage.
  2. Under the new CFPB rules, servicers, with limited exceptions, cannot initiate a foreclosure until a borrower is more than 120 days delinquent. The goal is to give borrowers time to submit an application for a loan modification or another alternative to foreclosure.
  3. Mortgage servicers can no longer start a foreclosure while they are also working with a homeowner who has submitted a complete application for help.
  4. Mortgage servicers now have to make sure the people who take calls from borrowers are able to answer questions and have access to critical documents.
  5. Servicers will have to give homeowners who ask timely, accurate information about their foreclosure status when asked.
  6. CFPB rules require mortgage servicers to help borrowers who fall behind on their mortgages to know all the options available to them. If a borrower submits a complete application for assistance early enough, the mortgage servicer must evaluate the borrower for all the options that may be available to the borrower.
  7. If the mortgage servicer denies a complete loss mitigation application sent in soon enough before foreclosure, the servicer must explain why the borrower was rejected. A borrower who
    filed a complete application soon enough before foreclosure is entitled to appeal mistakes the servicer may have made in evaluating the borrower for a loan modification.

Types of qualified mortgages

The CFPB included provisions for special-case exemptions. As a result, there are three types of qualified mortgages. These include:

General-definition qualified mortgages: These are mortgages meeting all the four requirements listed before.

GSE-eligible qualified mortgages. These mortgages were temporarily exempted from the 43% DTI requirement. The exemption was held until January 10, 2021. After the 2008 housing crisis, this adversely destabilized GSE loans, and the FHFA took control of them to restore them to a solid financial stand.

Loans eligible for insurance by FHA, VA, and USDA can also be considered as QMs despite the debt-to-income ratio until the agencies issue their own regulations.

Small-creditor qualified mortgages. Mortgage lenders with less than 2 billion in assets resulting from less than 500 private home mortgages per year (typically credit unions and small lenders) can refer to their mortgages as qualified mortgages as long as they keep these QM loans in their portfolios and verify and consider every borrower’s DTI as part of their lending criteria.

What are the pros and cons of qualified mortgages?

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks to consider.

Pros
  • Investor confidence in the secondary mortgage market.
  • Sets a cap on the fees and points borrowers pay (3% loan amount)
  • Lenders have to confirm borrowers can afford the mortgages payments before approval.
  • Shields borrowers from risky loan features.
Cons
  • More stringent eligibility requirements make it harder for borrowers to qualify for a mortgage.
  • Borrowers must meet debt-to-income requirements (minimum 43% DTI)

The primary reason the CGPB came up with the standards of Qualified Mortgage was to bring back investor confidence in the mortgage market. While qualified mortgages are designed to safeguard lenders and their stakeholders from these mass defaults, QMs also protect borrowers. The DTI and ability-to-repay requirements for qualified mortgages shield borrowers from getting into unaffordable mortgage payments. However, meeting the rigorous requirements of a QM can make it harder for homebuyers to qualify.

When to consider a non-qualified mortgage

Although less common, many lenders still offer mortgages that do not meet the QM standards. However, a lender’s willingness to relax some ability-to-pay requirements, such as accepting a DTI ratio higher than 43%, doesn’t mean they’ll take just any borrower. They could even look harder at the borrower’s finances than those providing QM loans.

The ideal candidates for non-qualified mortgages are wealthy borrowers with significant assets but little income. They might not meet the DTI ratio required for QM but you can prove their ability to liquidate assets or investments to make mortgage repayments.

First-time homebuyers with low to moderate-income who cannot meet QM DIT requirements may still qualify for some non-QMs but should expect higher fees and interest rates.

Do credit scores affect qualified mortgages?

Yes, credit scores affect qualified mortgages. Typically, if you have a higher credit score, you can expect better rates and terms.

However, qualified mortgage requirements don’t regulate interest rates. Lenders set interest rates based on a borrower’s creditworthiness. If you are planning to apply for a mortgage, it’s a good idea to check your three credit reports as soon as possible and take measures to fix any mistakes that could be hurting your score.

Key takeaways

  • A qualified mortgage (QM) is a home loan that meets certain requirements for secondary mortgage market trading and lender protection under the Consumer Protection Act and Dodd-Frank Wall Street Reform.
  • The Consumer Protection Act and Dodd-Frank Wall Street Reform of 2010 provided the regulations that define qualified mortgages.
  • To qualify for a mortgage, consumers must meet specific requirements to determine the borrower’s ability to repay.
  • Whether shopping for a mortgage (qualified or otherwise) it helps to have good credit and a low debt-to-income ratio.

 

Article Sources
  1. Mortgage rules – CFPB
  2. Ability to repay rules – CFPB
  3. Truth in lending act (Regulation Z) – Federal Register