The ‘New Normal’ in Mortgages

The numbers don’t lie: Unconventional mortgage loans are making a comeback.

In 2018, unconventional mortgage lending hit its highest rate since before the subprime mortgage crisis and the ensuing Great Recession. Whether or not you’re involved in the financial industry, that statement may worry you, since 1) subprime mortgages are often classified under the umbrella of unconventional mortgage lending, and 2) none of us want to go back to where we were circa 2008 or 2009 … at least in terms of the economy.

What many people don’t realize is that unconventional mortgage loans are more than just subprime mortgages. This category may also include loans through the Federal Housing Administration (FHA), the United States Department of Veterans Affairs (VA), the United States Department of Agriculture (USDA), or the Michigan State Housing Development Authority (MSHDA). These loans are backed either partially or fully by the government and are alternatives for individuals or families that, for whatever reason, cannot qualify for more conventional or traditional mortgage lending.

Why are mortgage loans like these on the rise? The biggest reason, especially in an area such as Traverse City, is a mismatch between the price of real estate and the average gross income. For one thing, wages have largely not risen proportionally to the rising costs of real estate. Our area is a high-demand real estate market with limited options for affordable housing. This situation, combined with other problems such as the prominence of student loan debt, has created a narrative where many people who want to buy homes struggle to qualify for conventional mortgage financing.

I have been involved in the mortgage lending industry for 40 years now. When I got started, the general wisdom was that the payment-to-income ratio on a mortgage loan shouldn’t exceed 28%, and that the customer’s ultimate debt-to-income ratio should not exceed 36%.

On paper, those numbers still look very reasonable. In practice, though, they prove to be unrealistic for many borrowers. With the price of real estate being what it is – and considering the high levels of debt that many people are carrying from student loans, car payments or credit card debt – not a lot of people can hit the 36% debt-to-income ratio necessary to qualify for a conventional mortgage under the old rules.

As a result, the rules have changed. These days, lenders are typically working with debt-to-income ratios closer to the 43-45% range. That’s the “new normal” in the industry. Even with these relaxed expectations not every customer can qualify for conventional lending.

The good news is that there are other options. Through unconventional mortgage lending, we can recommend other paths for people who might be looking at debt-to-income ratios in the high 40s or up into the 50s. There’s a balance, though. From 2001 to 2008, home loans were being approved with high debt-to-income ratios – think 63-65% – and we all know where that got us. If 65% of your income is going toward paying your mortgage, and if an additional 20-25% is going toward taxes, how much does that leave you to live on? In most cases, not enough, which is why so many of those pre-recession mortgages ended up defaulting.

I always encourage customers who are interested in pursuing unconventional mortgage loans to sit down for some financial counseling, whether with their personal financial advisor or with a mortgage lender like me. Many customers seeking unconventional loans have solid credit and have perhaps even demonstrated an ability to pay as much or more in monthly rent costs as they would pay on a mortgage bill. But because their incomes don’t clear a certain threshold, or because they are carrying too much other debt, they struggle to qualify for a conventional loan that would get them into the house they want to buy.

Is unconventional lending the right choice for these individuals? Or should they wait to buy a house until they can show more income or pay off some of that debt?

Ultimately, there is no “right” answer to these questions. I’ve always been fond of saying “life is a story problem”: Every customer’s story is a bit different, which means the right answer for one person is going to be different than what’s best for someone else. What is important to understand is that unconventional loans often carry higher risks and less favorable terms than conventional loans – from higher interest rates to shorter repayment periods. It is possible to buy a home with an unconventional loan and then refinance into a more traditional loan, once you are able to qualify for one. It is also possible to find yourself in a loan where the payments are a little too high and the interest is a little too steep.

Bottom line, if you are considering an unconventional loan, take the time to assess your financial situation from every angle and to make a long-term plan for your financial future. These loans can help people, but they can also hurt. Going in with a firm plan to improve your debt-to-income ratio over time can protect you and help you get the most out of whatever financing you choose.

Mike Nagy is vice president of mortgage lending at State Savings Bank in Traverse City. He has nearly four decades of banking experience. State Savings Bank has been financing homes in northwestern Michigan since 1901.