Alternative Lending: What Is It and What Do You Need to Know?
The top three reasons homebuyers were rejected for mortgages in 2018 were debt-to-income ratio, low credit score and income that couldn’t be verified, according to a 2018 report from the National Association of REALTORS. As rates and home prices push higher into 2019, aspiring homebuyers already having challenges qualifying may find it even more difficult to get a mortgage.
There is some good news: Alternative mortgage lending, or “non-prime” lending as it is more commonly referred to, is on the rise. It offers a variety of loan products that may help overcome the obstacles that kept you from getting a mortgage loan in 2018.
What is alternative mortgage lending?
In general, alternative mortgage lending refers to any method of providing a mortgage that doesn’t involve a traditional bank.
One of the fastest growing segments of alternative mortgage lending is known by the industry term “non-prime” or “non-QM.” The acronym QM stands for qualified mortgages. According to the Consumer Financial Protection Bureau, a qualified mortgage is a category of loans that have certain, more stable features that make it more likely to afford your loan.
Specifically, a qualified mortgage meets these requirements:
- The total debt-to-income ratio including mortgage payments must be 43% or less
- There can’t be any risky features like negative amortization or interest-only payments
- The fees and points charged must be 3% or less for loan amounts at least $100,000
- Lenders must document your ability to repay the loan
In order to verify your ability to repay your loan, lenders request documents to prove your income and assets, such as pay stubs, W-2s, tax returns, bank statements and retirement statements. They will also obtain a credit report showing your current credit card and installment loan balances and monthly payments.
Your employers can verify pay stubs, lenders can cross-check your W-2s and tax returns against the IRS database and federally-insured banking institutions can provide bank statements. As a result, these documents are the most acceptable to get approved for an FHA, conventional, VA or USDA loan.
Some borrowers, such as those with complicated tax returns or ones who had recent major credit issues, are boxed out lending because of the limits of standard ability-to-repay documentation requirements. They may be just a few years away from qualifying but have found a house that fits their needs now.
That’s where non-prime lenders come into the picture.
Who can benefit from non-prime loans
The non-prime products on the market right now provide options for people with bad credit, those who don’t have the traditional income documentation and borrowers who have higher debt-to-income ratios than what’s allowed for conventional, FHA or VA loans.
Non-prime lenders also provide niches for real estate investors looking for easier qualifying guidelines to purchase or refinance rental properties, as well as high-net-worth borrowers who can convert their assets into qualifying income.
Borrowers with bad credit
Buyers with bankruptcies and foreclosures must wait at least two to seven years before they can qualify for a VA, FHA, USDA or conventional loan (the length of the waiting period depends on the loan you’re applying for). This waiting period is known as a “seasoning period,” and it must pass before any mortgage loan can be made.
With non-prime, the waiting period can be as short as one day. One of the most common scenarios these programs address are “just-missed-foreclosure seasoning” issues — for example, your foreclosure happened 6 1/2 years ago, so you’re just shy of the seven-year seasoning period. With a non-prime loan, if you find a house you really like, you’re able to finance the purchase without having to wait until you hit the seven-year mark.
The Bureau of Labor Statistics showed that nearly 15 million people were self-employed through 2015, and with self-employed businesses come self-employed tax returns. Taking advantage of all of the tax shelters provided by having an S-corp, an LLC or a C-corp may help keep your tax burden to a minimum, but it can create problems when it comes time to qualify for a mortgage loan.
Fannie Mae, Freddie Mac, FHA and VA loan guidelines for self-employment can be very complex. If your income dropped from the previous year, the lender might not use any of that income to qualify. They may see such a decline as a sign that the business is failing and therefore, your income will be unstable. Even if your income increased more from last year, you may have to average it out with the prior year anyway.
Contrary to the advertising you may see online, there is no such thing as a stated income loan program anymore. While you might not need pay stubs, W-2s or tax returns, you’ll still need to show other proof of income.
One way to do that is to provide your bank statements. Lenders take an average of the monthly deposits flowing through your personal or business bank statements over 12 to 24 months, deduct a percentage for expenses and use the resulting number as your qualifying income.
Investors with multiple rental units, solid rental income and bad credit
Before the days of buying and flipping properties, there was a buy-keep philosophy of real estate rental investing. The concept was simple enough: Finance the purchase of multiple investment properties, keep the properties in good condition and have tenants make the payments.
The combination of tenants making payments and rising home values allowed investors to build up equity steadily. But the house flippers threw a wrench in buy-keepers’ business plans when they used subprime mortgages to acquire multiple properties with no down payments and no income documentation. When home values plummeted during the crisis, buy-flippers’ unsold inventory of properties went to foreclosure.
The high level of defaults led to a new restriction on how many financed properties investors could own. Fannie Mae and Freddie Mac cap the total number of financed properties at 10. Many banks won’t allow more than four.
Non-prime lending allows investors to acquire or refinance investment properties regardless of how many financed properties they currently own.
For investors with excellent cash flow with complicated tax returns or recent credit problems, programs that only look at debt-service coverage ratio are available. Debt-service coverage ratio is the amount of debt you’ll take on when purchasing the property divided by the amount of rental income you expect to take in from the property. The lender focuses exclusively on debt-service coverage and does not look at your personal income and debt, as would be the case with a normal debt-to-income ratio calculation.
You’ll need to verify your new mortgage payment isn’t more than your current rent by providing a lease or an appraisal that supports the market rent of your property as estimated by a certified residential appraiser. In other words: If your new mortgage payment is $1,000 a month, the market rent must be at least $1,000 per month.
With an acceptable debt-service coverage ratio, even borrowers with recent late payments on their mortgages, foreclosures within 24 months and first-time investors can be approved without the standard conventional loan reserve requirement of six to 12 months.
High net worth borrowers
Non-prime lenders have introduced asset-depletion programs that are much more competitive than the ones normally offered by institutional banks. The idea is simple: Take your total assets, divide them by a lender-chosen time period, and use that as income.
Many lenders will use a timeline that is reasonably close to the term of the loan, like 20 years. So if you have a checking account with $200,000 in it, dividing it by 240 (20 years x 12 months) gives you an extra qualifying monthly income of $833.33/month.
Non-prime lenders offer the same program, except with a much shorter qualifying income period — as brief as five years in some cases. Using the same $200,000 example above, dividing your asset by 60 months gives you $3,333 of monthly qualifying income.
What are the requirements?
Based on the marketing materials available from a number of non-prime lending sources, the following should give you an idea of requirements and features of non-prime loans. The amount of money you need to put down and your interest rate will depend on your credit scores and the type of documentation used for qualifying income.
The non-prime market is projected to double or triple in volume by 2019, so check with a mortgage bank or broker offering non-prime loan programs to find out if there have been any changes should you decide to go down the non-prime mortgage application path.
- FICO requirements vary by product and down payment: Of the non-prime lenders researched, the low score threshold was 350. Programs requiring minimal documentation like bank statement only required higher FICO scores than for fully documented loans.
- Down payments: The lowest down payment found is 5%, but this assumed a 720 or higher FICO with multiple months of monthly mortgage payment reserves, and other restrictions.
- Debt-to-income ratios: The highest debt-to-income ratio found was 55%, with higher FICO scores and more reserves. For no-ratio programs (such as the no income documentation debt coverage ratio for investor properties program) the down payment requirement was much higher.
- Self-employment history for bank statement: The bank statement programs reviewed will require you can prove your business has been in existence for at least two years.
What kind of terms you can expect
- Interest rates: With higher risk comes higher interest rates. Your interest rate will depend on your credit scores, how little or much you put down, and how much or how little documentation you provide. The lower the scores, the less the down payment and the less the documentation, the higher the rate will be.
- Fees: There is no uniform fee schedule with lenders, and the amount charged will likely depend on the mortgage bank or mortgage broker that helps place the loan.
- Risky features: Most of the programs offer the most competitive rates on five- to seven-year, adjustable-rate loans. Fixed rates may be available, but the rates are substantially higher. Prepayment penalties were not featured, but some programs did allow for interest-only payments during the adjustable rate period.
The prequalification process for non-prime loans
Normally when you apply for a mortgage loan using an online application, you can input your income, assets and credit, and a loan officer can prequalify you based on that information. Depending on the type of documentation you provide for your income, the process may work a little bit differently for a non-prime loan prequalification.
This is especially true when you are using bank statements instead of tax returns to qualify for a loan. Non-prime mortgage lenders have different methods for calculating how much income they will use based on the deposits on your bank statements and the type of business you are in.
You’ll want to call at least two different lenders that offer bank statement programs and provide you with rate comparisons to see if there is a difference in how much qualifying income they are willing to give you. Since the rates are significantly higher and down payment requirements in most cases will be at least 10%, you’ll want to have a solid idea of what your payment will look like. The difference between a 5% rate and 9% rate on a $200,000 loan is $535/month in payment.
Here’s what you can expect from the non-prime prequalification process:
- More documents upfront:
- 12-24 months personal or business bank statements, all pages
- All pages of foreclosure paperwork, bankruptcy papers with all schedules, tax lien payment arrangements with proof of recent payment, proof of judgments paid off
- Letters of explanation for all major credit problems
- A longer waiting period for prequalification:
- Lenders have to review all the pages of bank statements to prequalify correctly
- All pages of credit documents like bankruptcies and foreclosure must be reviewed
The process may take some extra time, but it will be worth the effort if you are able to overcome the most common reasons loan applications are getting rejected.
How is non-prime different than subprime?
The term non-prime may bring back memories of the subprime loans that are blamed for much of the downfall of the housing market a little over a decade ago. Non-prime loan programs may have some of the features of the subprime loans of yesterday, but lenders are held to much higher lending standards. All mortgage lenders are regulated by the Consumer Financial Protection Bureau, a consumer watchdog agency created by the government to prevent the kind of abuses that caused so many people to lose their homes during the housing crisis.
Non-prime loans don’t have to meet qualified mortgage standards, but lenders must still make a good-faith effort to show that they are making a loan you can repay. The CFPB has a lot of power to hold lenders accountable, and you have direct access to file complaints against any mortgage company you think didn’t follow the rules.
Non-prime loans are not the same as the subprime loans of the past, because of the ability-to-repay requirements the CFPB put on lenders after the housing crisis.
But because of their high rates and somewhat risky terms, non-prime loans make the most sense as a short-term solution for someone who wants to buy property now and has the ability to pay for it. You should have a plan to refinance a non-QM loan into a qualified mortgage product in the future to reduce the long-term costs of having a non-prime loan.