What Is a Non-Agency Loan? And How Does It Work?

The mortgage market offers various financing options, broadly categorized into agency and non-agency loans. While agency loans, backed by government-sponsored enterprises, represent a significant portion of the market, non-agency loans cater to unique borrower needs. This article defines non-agency loans and explains their operational mechanics, providing clarity on a less conventional segment of home financing.

Defining Non-Agency Loans

Non-agency loans are mortgages not purchased or guaranteed by government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. They are also not insured or guaranteed by government agencies like Ginnie Mae, which backs loans from the Federal Housing Administration (FHA), Department of Veterans Affairs (VA), and U.S. Department of Agriculture (USDA). These loans operate outside the standard “conforming” limits and underwriting guidelines set by these entities. Private lenders originate these mortgages, holding them in their portfolio or pooling and selling them as private-label mortgage-backed securities (PLMBS) to investors.

Fannie Mae and Freddie Mac provide liquidity to the mortgage market by purchasing conforming loans from originators, allowing lenders to make more loans. Conforming loans must meet specific criteria regarding loan amount, borrower creditworthiness, and property type. When a loan does not fit these criteria, it falls into the non-agency category. This lack of government or GSE backing means the credit risk is borne directly by the originating lender or the private investors who purchase the securitized pools. The terms and conditions of non-agency loans are determined by market forces and the specific risk assessment of the private entities involved.

Types of Non-Agency Loans

Non-agency loans encompass several distinct categories, each designed to serve borrowers or property types that do not fit the strict criteria of agency financing.

Jumbo Loans

One prominent type is the Jumbo loan, specifically for loan amounts that exceed the conforming loan limits set annually by the Federal Housing Finance Agency (FHFA) for Fannie Mae and Freddie Mac. These loans are typically sought by borrowers purchasing high-value properties and often require excellent credit scores and substantial down payments due to their larger size.

Non-Qualified Mortgage (Non-QM) Loans

Another significant category is Non-Qualified Mortgage (Non-QM) loans, designed for borrowers who do not meet the Qualified Mortgage (QM) rules established under the Dodd-Frank Act’s Ability-to-Repay (ATR) provisions. QM rules define a category of loans with certain features that make them easier for borrowers to repay, such as limitations on points and fees, and a requirement that the borrower’s debt-to-income ratio not exceed a certain percentage. Non-QM loans offer more flexible underwriting for individuals with complex income structures, such as self-employed individuals, business owners, or those with significant assets but irregular income streams. These loans allow lenders to assess a borrower’s repayment ability using alternative documentation or methods, such as bank statements instead of traditional tax returns.

Historically, the non-agency market also included loan types like Alt-A and subprime mortgages, which played a notable role before the 2008 financial crisis. Alt-A loans typically targeted borrowers with good credit but who chose not to fully document their income or assets. Subprime loans were offered to borrowers with lower credit scores or other significant risk factors. While these specific products largely disappeared or were heavily reformed following the crisis, they serve as historical examples of how loans that did not meet conventional underwriting standards were categorized within the broader non-agency segment.

Key Characteristics

Non-agency loans possess distinct characteristics that differentiate them from their agency counterparts, primarily stemming from their lack of government backing.

Flexible Underwriting

A feature is their underwriting standards, which tend to be more flexible and customized. Unlike agency loans, which adhere to rigid debt-to-income ratios and credit score requirements, non-agency lenders can tailor their criteria to accommodate a wider range of borrower profiles. This flexibility allows for the consideration of alternative income documentation, such as bank statements for self-employed individuals, or a focus on asset-based lending for high-net-worth individuals, enabling financing solutions for unique financial situations.

Higher Costs

Due to the increased perceived risk from private lenders and investors, non-agency loans generally come with higher interest rates and fees compared to conforming agency loans. The absence of a government guarantee means that the lender or investor assumes the full credit risk, which is priced into the loan terms. Borrowers might encounter interest rates that are 0.5% to 2% higher than agency loan rates, along with higher origination fees or discount points, which can range from 1% to 5% of the loan amount. These elevated costs compensate the private market for taking on loans that do not fit the standardized, lower-risk profiles preferred by GSEs.

Private Securitization

Another defining characteristic is their securitization method, often involving private-label mortgage-backed securities (PLMBS). While agency loans are pooled into agency MBS and guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae, non-agency loans are aggregated and sold as PLMBS without such government backing. This means that the investors purchasing PLMBS bear the full risk of default on the underlying mortgages, making thorough due diligence on the loan pool crucial.

Higher Risk Profile

Non-agency loans inherently carry a higher risk profile for investors and lenders. Without the implicit or explicit government guarantee, the market for PLMBS is smaller and less liquid than the agency MBS market. This higher risk is reflected in the pricing of these securities and the yields demanded by investors. The risk assessment for non-agency loans considers factors beyond standard credit scores, including the lender’s specific underwriting processes, the loan-to-value ratios, and the overall economic environment.

Borrower and Lender Considerations

Non-agency loans serve a specific segment of the population whose financial situations or property types do not align with conventional lending standards.

Borrower Benefits

For borrowers, these loans are often the only or best option when they are high-net-worth individuals with substantial assets but less traditional income streams, such as those with significant investments or fluctuating business profits. Self-employed individuals, whose income may be difficult to verify through standard W-2 forms, frequently turn to non-agency lenders who can underwrite based on bank statements or other alternative documentation. These loans also cater to unique property types or investment strategies. For example, some non-agency lenders specialize in financing properties with multiple units beyond the four-unit limit for conforming loans, or properties that are not primary residences, such as investment properties with higher risk profiles. Borrowers seeking to purchase luxury homes exceeding conforming loan limits, or those with recent credit events like a past bankruptcy or foreclosure who have since rebuilt their financial stability, may also find solutions within the non-agency market.

Lender Motivations

On the lending side, various financial institutions originate and hold non-agency loans, driven by motivations distinct from those focusing primarily on agency loans. Private mortgage lenders, often specializing in niche markets, are significant players in this space, developing specific programs for non-QM or jumbo borrowers. Investment banks may also be involved, particularly in the securitization of these loans into private-label mortgage-backed securities, facilitating their sale to institutional investors seeking higher yields.

Portfolio lenders, including some credit unions and community banks, may opt to hold non-agency loans on their balance sheets. These lenders are motivated by the potential for higher yields compared to agency loans, which offer lower returns due to their lower risk and government backing. By serving niche markets, non-agency lenders can attract borrowers who are willing to pay a premium for financing tailored to their specific needs.