What Is a Nonconforming Mortgage?

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

These may be contrasted with conforming mortgages.

Key Takeaways

  • A nonconforming mortgage is a home loan that does not conform to GSE guidelines and so cannot be resold to agencies like Fannie Mae or Freddie Mac.
  • As a result, these loans often carry higher interest rates than conforming mortgages.
  • For instance, mortgages that exceed the conforming loan limit are classified as nonconforming, and are called jumbo mortgages.
  • Other than the loan size, other mortgages may become nonconforming based on borrower’s loan-to-value ratio (down payment size), debt-to-income ratio, credit score and history, and documentation requirements.

Understanding Nonconforming Mortgages

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

Although private banks initially write most mortgages, they often end up in the portfolios of Fannie Mae and Freddie Mac. These two government-sponsored enterprises (GSE) 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 secured by a collection of mortgages which 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 which 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 unsellable loans must either stay in the bank’s portfolio or sell to entities specializing in the secondary market for nonconforming loans.

Types of Nonconforming Mortgages

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

The most common nonconforming mortgage is what’s often called a jumbo mortgage. Jumbo mortgages are 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, it can be as high as $822,375 (for example, in New York City or San Francisco).

But mortgages don’t have to be jumbo to be nonconforming. A low down payment can trigger nonconforming status. The threshold varies but could be 10-percent on a conventional mortgage or as little as 3-percent on an 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 also usually required.

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.