How to Explain Nonconforming Mortgage Loans?

The best way to explain nonconforming mortgage loans is to start with the US government.  In order to stimulate housing construction and assist home purchasers, the government set up two organizations called the Federal National Mortgage Association (FNMA), nicknamed Fannie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), nicknamed Freddie Mac. These organizations perform many similar functions and fuel the housing market by buying mortgage loans from conventional lenders and reselling them to private investors.

Mortgage lenders often resell the loans they underwrite to financial institutions such as money funds, insurance companies, and private investors in order to make a quick profit, mitigate the risk, and have more money to lend to others.  Fannie Mae and Freddie Mac make all this easier for lenders by buying any mortgage loan that meets certain standard criteria from any lender who wished to sell. This further opens up the market for mortgage trade among lenders independent of Fannie Mae or Freddie Mac because it turns mortgages into a type of commodity that is easily bought and sold. Fannie Mae and Freddie Mac constitute a major force in the mortgage market and purchase over 20% of the mortgage loans issued in the US.

So as to not subsidize lavish home purchases, Congress set caps on the size of the mortgages Fannie Mae and Freddie Mac can purchase.  Therefore, any mortgage amount above these caps, which depend on the property size and whether you live in the continental US or not, is more difficult for lenders to resell, and this translates to some difficulties presented to the borrowers as well. Mortgage loans above the limits are called nonconforming mortgage loans and are also known as jumbo loans.  Nonconforming mortgage loans typically require higher down payments and have interest rates between 3/8 to 1/2 percentage points higher than conforming loans.

So if you’re buying an expensive home you’ll be paying even more for the money you borrow. 2004 limits for a single unit home in the continental US is about $333,000.  If you find yourself wanting to buy a house at a little above the limits, there are a few things you can do to bring you back to “conformity”:

1. Get a smaller mortgage and raise cash elsewhere to make up the difference.
2. Obtain a 80-10-10 mortgage.  80-10-10 is a name given to mortgages in which you get a second mortgage to finance part of the down payment.  In an 80-10-10 deal you put down 10%, get a primary mortgage of 80%, and a 10% second mortgage to cover the rest of the 20% down payment mortgages require.  In the case of a nonconforming mortgage, you’ll use the 10% second mortgage to reduce the size of the primary mortgage instead of shrinking the down payment.  Note that the percentages are flexible, i.e. the second mortgage doesn’t have to be exactly 10%.