Unconventional Mortgage Loans Are Making a Comeback

In 2018, the number of unconventional mortgages increased to the highest level since the mortgage meltdown in 2008. Unconventional mortgages include subprime loans, which are made to borrowers with blemished credit; loans made to borrowers without a Form W-2 or other standard documents; and other loans that don’t meet the standards set by the Consumer Financial Protection Bureau.

Does that mean we’re headed back to the bad old days that led to the housing meltdown? Probably not, although if there’s a rise in delinquencies, it could signal trouble ahead, says Guy Cecala, publisher of Inside Mortgage Finance.

While the number of unconventional mortgages has grown, they were still less than 3% of loans made in 2018, compared with 39% in 2006, right before the housing bust began. In addition, many of the loans are only slightly unconventional, says Cecala. For starters, most lenders must, by law, make a good-faith effort to determine that a borrower has the “ability to repay,” he says. And lenders that underwrite these mortgages usually look for ways to offset risk. For example, they’ll use a high credit score and a large down payment to offset the risk of a high debt-to-income ratio, limited documentation or an interest-only loan.

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Most of the bad-apple loans that contributed to the housing crisis are long gone. Loans that result in negative amortization—the loan balance grows rather than shrinks—have disappeared. Interest-only loans have returned to their traditional role as short-term loans for wealthy people buying expensive homes with a down payment of, say, 50%, says Cecala.

The primary reasons that borrowers took unconventional loans in 2018 were that they had limited or alternative documentation, they had a debt-to-income ratio above 43%, or they wanted an interest-only loan, according to CoreLogic, a financial data and analytics company. Borrowers who are self-employed or earn commissions may have a harder time verifying their income, so lenders may rely on bank statements rather than tax returns. Qualifying with a higher debt-to-income ratio is common among younger borrowers, who may have student loans, and retirees with fixed incomes, who spend a higher portion of their income on housing.

Before the mortgage meltdown, a large percentage of questionable loans were securitized and sold to investors. In 2018, about $100 billion in non-agency mortgage securities were created (that is, mortgages that weren’t backed by Fannie Mae, Freddie Mac, the Federal Housing Administration or Veterans Affairs). That’s the most since 2007, but it’s still just 10% of what it was during the boom. Lenders may be more willing to loosen underwriting to drum up business, especially if it would distinguish them from competitors, Cecala says. But in the worst case, only a handful of lenders or investors will fail, he says.