Usually the term “non-conforming” in the financial industry is used when discussing jumbo mortgage loans. In most cases a jumbo mortgage loan will be much higher than the typical mortgage, reaching as high as you can imagine, and going as low as $350,000.
Very often non-conforming loans are approved and funded for real estate ventures, and a non-conforming loan will allow people who are non-residents of the United States to invest great amounts of capital in American real estate.
There are stipulations and rules (laws) put forth by Freddie Mac and Fannie Mae, which don’t allow highly speculative lending on real estate unless “they conform” with the regulations in place. (Freddie Mac stands for Federal Home Loan Mortgage Association and Fannie Mae stands for Federal National Mortgage Association)
The Way Non-Conforming Loans Work
The way it usually works is this; the non-conforming loan has interest rates that are much higher than your typical conforming mortgage. Interest rates will of course be determined by your credit score and what kind of recent financial history you have in the credit agency databases worldwide.
Private borrwers are often wanting to invest in mortgages and real estate ventures based on speculation and they will use some key brokerages to help them as a third-party (an intermediary) between the borrower and themselves. These brokerages can get an approval through quickly and without the typical hassles involved with a traditional banking institution. These kinds of loans are what we would call “cowboy financing” because it’s like the Wild Wild West in real estate. There are not nearly as much regulatory hurdles in the way of investors who want to capitalize on their investment. As a matter of fact, in late 2008 and 2009, during the recession in the United States, these real estate speculators really pumped up their private investment in American real estate. They would have used non-conforming, jumbo mortgages.
Do not misunderstand me when I suggest that it is usually speculators and investment companies who use non-conforming loans, because it is very common for your typical “mom and pop” to seek approval of a non-conforming loan when they are investing in a second property (mortgage).
If any person, entity, or investment Corporation, try to use a traditional bank for this kind of financing, they wouldn’t have a chance, because most banks still have to lend money according to government regulations set forth by Fannie Mae and Freddie Mac, as I have mentioned above. There is really only one choice if you want to get one of these jumbo loans, and that is to find a private investor or brokerage that has the means (resources) to come up with this kind of funding.
AKA, Hard Money Loans & Bridge Loans
In many ways there are similarities between non-conforming loans and hard money loans because the regulatory aspects are thrown out the window for expediency and profit. You will often see non-conforming loans being used on large civic projects such as shopping malls, medical centers, strip malls, parks, gas stations, motorhome and RV parks, recreational centers, and theater buildings. Often these non-conforming loans are purely commercial and are referred to as Bridge Loans.
Keep in mind that if you are looking for a non-conforming loan for residential purposes there are more regulations attached, and there are usually much higher interest rates involved. Every state has its own different legal limits and regulations that have to be kept in mind as well if you are investing in real estate in residential areas.
With the higher interest rates that these hard money lenders charge comes more flexibility and ease of process. You’ll often see that there are brokers involved in the process, because they worked between the borrower and the lender.
Typical Example of a Non-Conforming Residential Mortgage
A typical example of a non-conforming jumbo loan would be when a borrower has recently declared bankruptcy (this is example is for an individual family) and they have no credit to their name(s) for the next seven years. They need to have a home so the family has a roof over it’s head, and they have a larger family that can’t use some small apartment. There only real option is to get a house and try to rebuild their credit rating at the same time.
This family (mother and father or whatever) would go to a brokerage which is a private entity. The brokerage has investors who want to capitalize on their cash (via interest) as much as possible, and these investors all “chip in” to finance the property this family desires. The brokerage firm makes a slice of profit from the transaction, while the investors all make a great profit on the interest they are charging in the deal.
Typically these kinds of non-conforming loans will charge an interest rate between 24% and 30%, which is extreme, to say the least. However, there are people that choose to this path when they know they are going to be flush with cash in the very near future. The borrower is happy because they get their house or property. The brokerage is happy because they get a slice of the commission, and the lenders are happy because they get a higher return on the dollar.
Defaulting on Non-Conforming Loan
What happens if the borrowers involved with a non-conforming loan default on their payments? This sets quite a few things in motion, depending on the agreement that was struck up, and the regulations of the State or Province. There is a very large penalty fee that has to be paid by the borrower if they are ever late on payment(s), and if they default altogether, they lose their investment on the property.
You must understand that with non-conforming loans the down payment and collateral has to be quite high. A typical residential non-conforming loan will not be approved by the brokerage, and/or the lenders, unless there is between 30% to 40% down.
So what happens if the non-conforming borrower simply goes AWOL on the deal and disappears? The brokerage firm and the lenders reap the rewards. The lenders and the brokerage make even more money on the deal because they have simply soaked up the large down payment the borrowers had to make to get the deal struck.
This seems quite nasty and predatory in some ways, but if you look at the way businesses run in the Americas, this is just a fact of life. Sometimes you have to take a big risk to get that shopping mall, or private civic project, completed so there is no other way to go to get around the federal-level and state-level regulations involved in lending.
Another Example of a Non-Conforming Loan
So what happens on a $600,000 property when the hard money borrower borrows $400,000 and they have a down payment of $200,000?
The lenders that all pooled in, via the brokerage firm, will simply get all of the borrower’s equity, and they will resell the property (or project) to another willing buyer. In other words, save for the legal hassles involved which the brokerage firm handles for the lenders, when a hard money borrower defaults and walks away on their investment, it’s a big win-win for the lenders.
Shady Hard Money Lenders
I remember seeing an example of this with commercial real estate. The “company” would sell the commercial real estate to a willing buyer using a non-conforming financing agreement. The borrower had to provide 50% of the loan to get the agreement finalized. These commercial properties cost $300,000 each, so the borrower had to risk hundred $150,000. Once the borrower moved into the commercial real estate, they found out that the business was not viable (which the brokerage already knew very well), because of some hidden factors involved, such as location, and the reality of the local market. The company that sold the property is connected with the company that lent the money, and lo & behold – the borrowers $150,000 investment goes down the drain, and scooped up by the fraudulent lenders.
Fortunately this example is rare in business (well rare enough anyway). If you do your homework, and due diligence, you will not be scammed in this kind of a non-conforming loan agreement.
Here is a very good quote which I will paraphrase.
“Typically, non-conforming loans always carry a maximum limit on the absolute total monies lended depending on the kind of purchase involved.”
In other wordds, there are different limits set forth by federal regulators on what a conforming loan is. The limits vary depending on the kind of real estate involved in the purchase, and these properties are usually single-family homes, larger commercial properties, and dual family home such as duplexes.
Whenever the loan amount is higher than the typical limit of the particular property involved (single-family dwelling, two family dwellings, large properties, residential mansions, and commercial real estate) than the mortgage, is given the tag “non-conforming”.
If for some reason the buyer of a home needs a mortgage, and they have a very poor credit rating (such as bankruptcy) they may still get financed because they have special mitigating circumstances in their case(s). This usually means that they have access to large capital coming in on a monthly and yearly basis, but for some reason in the past they have had their credit rating damaged significantly.
Often, you can see this with business owners and entrepreneurs. You will see an entrepreneur who has “lost everything”, including their credit rating, but over the last 15 to 20 years their financial backer (traditional bank) has made a great profit over the years. So in this case a non-conforming loan can go forward because the bank is very confident they will see all of their interest – in spades. The bank is happy with this because they get to charge quite a lot and interest, and they have confidence in the borrower they are dealing with, and a confident they will get all of their money back – including “the vig”.
Also, if the loan being considered by the lender, or bank, is quite large and the collateral used for security on the property is atypical, but deemed to be worthy by the banks, the loan may go through. Anything can trigger the outcome of a non-conforming loan if the assest collateral is not seen by the financial industry as a worthy, and begin deemed “low risk”.
A good example of this would be if a high-end art dealer, or car collector, had some rare investments that the bank felt very comfortable with taking on as security collateral. The private lender knows that an original Monet painting has great worth, but artwork would not usually be used as collateral by any traditional financial institution. This would be a non-conforming loan, because it falls away from the usual standards and laws. Like I said, this is like the wild wild West, and these are cowboy loans.
Non-Conforming Loans are Usually Short Term
I’m sure that some readers would ask themselves, ‘Why would someone borrow large amounts of capital at such high interest rates?’
The answer is that these loans are short term. Almost always, non-conforming loans are short term so the Interest on the principal is not the issue. These loans are usually borrowed on the premise that the principal will be paid off quickly, reducing the cost of borrowing greatly.
Real estate speculators generally plan to “flip” the property(s) in short order and maximize their profit, and “get out” before the interest can ever run up out of control.
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