Two government-created companies dominate today's mortgage market -- the Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Loan Mortgage Corporation, known as Freddie Mac. These firms exist to help banks make home loans. Their role is to buy bank mortgages after they're funded, thereby putting funds back into the system for banks to use for new loans. Without these companies, banks would quickly run out of money to lend, and many people would not be able to buy a home. Because these two entities are such a big part of the mortgage market today, they set rules for the loans they purchase. Loans that don't follow these rules are called non-conforming mortgages. Non-conforming portfolio lenders make loans that don't qualify for Fannie Mae and Freddie Mac purchases.
Fannie Mae and Freddie Mac operate with the same loan size limits, but these caps vary geographically. They recognize that real estate prices in some areas of the country tend to remain higher than others, so they periodically designate certain areas as "high cost" zones and set caps. Defining these limits is an annual event, and the companies consider recent economic conditions and home price data. In periods of economic stability, the limits may go for several years without changing. Multi-unit properties, up to a maximum of four units, have access to larger loan sizes.
Mortgage loans must also meet loan-to-value rules. In addition to the raw dollar amount, Fannie Mae and Freddie Mac have caps on the allowable loan size compared with the property value. They calculate the loan-to-value ratio by dividing the loan amount by the property's appraised value. There are maximum ratios for primary residences, second homes, rental properties and cash-out refinances. You can borrow the most on your primary residence, with smaller loan-to-value ratios allowed on non-owner-occupied properties and when the loan is to take equity out of the property. Fannie Mae and Freddie Mac consider your primary home mortgage to be the safest of the group, as you are most likely to keep that mortgage current with payments to protect your home.
Lenders want to be compensated for having to keep the non-conforming loans on their books. They will usually charge higher rates and fees than for conforming loans, and will make fewer portfolio deals available. Also, to compensate for the risk, banks will require more borrower equity. These actions limit consumer choices for non-conforming loans, but keep riskier loan levels low.
For borrowers willing to pay higher rates, and put in more equity due to lower loan-to-value ratios, non-conforming loans serve a valuable purpose. They can buy a more expensive home than with conventional mortgages. They may also be able to get more flexible repayment terms, such as interest-only or quarterly payments, than on conforming loans due to the outside rules.
- Creatas/Creatas/Getty Images