Non conforming loan: Meaning, Criticisms & Real-World Uses

What Is Non Conforming Loan?

A non-conforming loan is a type of loan that fails to meet the specific guidelines established by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. These guidelines, which primarily define a conforming loan, relate to loan size, borrower credit score thresholds, and debt-to-income ratios. Because non-conforming loans do not adhere to these standards, they cannot be sold to or guaranteed by Fannie Mae or Freddie Mac in the secondary mortgage market. Consequently, lenders often retain these loans in their portfolios or sell them to private investors, making them a specialized segment within mortgage finance. The primary characteristic distinguishing a non-conforming loan is its deviation from the established "conforming loan limits" set annually by the Federal Housing Finance Agency (FHFA).

History and Origin

The concept of non-conforming loans is intrinsically tied to the establishment and evolution of the U.S. housing market's secondary mortgage market. In the aftermath of the Great Depression, the U.S. government created entities like Fannie Mae (1938) and Freddie Mac (1970), known as government-sponsored enterprises (GSEs), to stabilize and provide liquidity to the mortgage market. These GSEs standardized mortgage products, setting limits on loan amounts they would purchase, thereby creating the category of "conforming loans." Mortgages exceeding these limits or not meeting other GSE criteria automatically became non-conforming.

The Federal Housing Finance Agency (FHFA) is responsible for setting the annual conforming loan limits for mortgages that Fannie Mae and Freddie Mac are legally allowed to purchase. These limits are adjusted annually based on the change in the average U.S. home price, as mandated by the Housing and Economic Recovery Act of 2008 (HERA). For instance, in most of the U.S., the baseline conforming loan limit for a one-unit property increased to $806,500 in 2025.⁸ Loans exceeding this amount are commonly known as "jumbo loans," a prominent type of non-conforming loan.

Beyond size, other factors have historically led to loans being deemed non-conforming. For example, during the mid-2000s, there was a proliferation of "nontraditional mortgage products," such as interest-only mortgages and payment option adjustable-rate mortgages, which allowed borrowers to defer principal or even interest payments.⁷ Regulatory bodies, including the Office of the Comptroller of the Currency (OCC) and the Federal Reserve System, issued joint guidance in 2006 to address the inherent risks of these nontraditional products due to concerns that borrowers might not fully comprehend the associated payment shock and increased [risk management](https://diversification.[⁶](https://www.occ.gov/news-issuances/federal-register/2006/06fr1246.pdf)

Key Takeaways

A non-conforming loan does not meet the underwriting standards set by Fannie Mae and Freddie Mac, primarily regarding loan amount limits.
These loans, such as jumbo loans, cannot be sold to or guaranteed by GSEs, meaning lenders typically hold them or sell them to private investors.
Non-conforming loans often carry higher interest rates and require stricter borrower qualifications due to increased risk for lenders.
They are more prevalent in high-cost housing markets where property values exceed standard conforming loan limits.
Specialized non-conforming products may also include those with non-traditional features or for borrowers with unique financial profiles.

Interpreting the Non Conforming Loan

A non-conforming loan signifies a financing arrangement that falls outside the conventional criteria for purchase by government-sponsored enterprises. When a loan is designated as non-conforming, it typically indicates one of two primary scenarios: either the loan amount exceeds the current conforming loan limit, or the borrower's financial profile (e.g., lower credit score, higher debt-to-income ratio) does not meet the stringent underwriting standards.

From a borrower's perspective, qualifying for a non-conforming loan often necessitates a higher credit score, a larger down payment, and more substantial reserves. Lenders view these loans as carrying greater risk management due to their inability to be readily sold into the liquid secondary market, which means the lender bears more of the default risk. Therefore, non-conforming loans typically come with higher interest rates compared to conforming loans.

Hypothetical Example

Consider Jane, who wishes to purchase a home in an expensive metropolitan area. The purchase price for her desired property is $1,100,000. She plans to put down 20%, requiring a loan amount of $880,000.

In this scenario, let's assume the current conforming loan limit for a single-family home in Jane's county is $806,500, as set by the FHFA for most of the U.S.⁵ Since Jane's required loan amount of $880,000 exceeds this limit, her mortgage would be classified as a non-conforming loan, specifically a jumbo loan.

When Jane applies for her mortgage, the lender will assess her application with different criteria than for a conforming loan. She might face a higher interest rate and be required to demonstrate a very strong credit score, stable income, and significant liquid assets. The lender knows that this specific $880,000 mortgage cannot be sold to Fannie Mae or Freddie Mac, meaning the lender will either keep the loan in its own portfolio or sell it to a private investor market that specializes in these larger, more individualized mortgages.

Practical Applications

Non-conforming loans are crucial in several segments of the housing market. Their most common application is for properties with values exceeding the standard limits set for conforming loans. In high-cost areas, such as major metropolitan centers, a significant portion of home purchases necessitates non-conforming financing. These "jumbo mortgages" allow individuals to finance homes that would otherwise be out of reach if constrained by conforming limits.

Beyond loan size, non-conforming loans also cater to borrowers with unique financial situations. For instance, individuals who are self-employed, have complex income structures, or possess credit histories that don't fit strict automated underwriting systems may find non-conforming options better suited to their needs. Lenders offering these loans often employ more flexible underwriting, evaluating the overall financial picture of the borrower rather than adhering rigidly to standardized metrics.

Furthermore, the market for non-conforming loans can be influenced by broader economic conditions and interest rate environments. During periods of market turbulence, the availability and pricing of non-conforming loans can become more volatile, impacting borrowers seeking larger mortgages.⁴ Financial institutions that originate these loans may hold them in their portfolios or package them into private mortgage-backed securities that are sold to investors outside of the GSE framework.

Limitations and Criticisms

While non-conforming loans offer essential financing solutions for many, they come with inherent limitations and criticisms. The most significant drawback for borrowers is typically higher interest rates and stricter qualification criteria. Since these loans cannot be sold to government-sponsored enterprises (GSEs), lenders bear the full credit risk management of the loan. This increased risk translates into more conservative lending practices, often requiring higher credit scores, larger down payments, and more substantial post-closing liquidity from borrowers.

Another limitation is the potentially smaller pool of lenders offering non-conforming products compared to conforming loans. Not all financial institutions have the capacity or desire to hold large mortgage portfolios or access the private secondary markets necessary for these loans. This can limit a borrower's options and potentially lead to less competitive terms.

Historically, some non-conforming products, particularly certain "nontraditional mortgage products," faced criticism for their complexity and potential for payment shock. Regulators expressed concerns that borrowers might not fully understand the terms of loans allowing for deferred principal or negative amortization, leading to increased risk of default.³ This led to guidance emphasizing clearer disclosures and prudent underwriting standards for such products.

Non Conforming Loan vs. Conforming Loan

The primary distinction between a non-conforming loan and a conforming loan lies in their eligibility for purchase or guarantee by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.

Conforming Loan: A conforming loan adheres to specific standards set annually by the Federal Housing Finance Agency (FHFA). These standards dictate the maximum loan amount (the "conforming loan limit"), as well as borrower qualifications such as credit score and debt-to-income ratios. Because they meet these criteria, conforming loans can be bought by Fannie Mae and Freddie Mac, which provides liquidity to the mortgage market and allows lenders to offer more standardized and often lower interest rates.
Non-Conforming Loan: A non-conforming loan does not meet one or more of the GSE guidelines. The most common type is a "jumbo loan," which exceeds the conforming loan limit. Other non-conforming loans may include those where the borrower's financial profile falls outside the GSE's strict underwriting criteria, or loans with unique structures not recognized by the GSEs. Lenders typically retain these loans in their portfolios or sell them to private investors, meaning they carry greater risk management for the originating financial institution. This increased risk usually translates to higher interest rates and more stringent qualification requirements for the borrower.

FAQs

What is a jumbo loan?

A jumbo loan is the most common type of non-conforming loan that exceeds the conforming loan limits set by the Federal Housing Finance Agency (FHFA) for mortgages eligible for purchase by Fannie Mae and Freddie Mac.² These loans are typically used to finance high-value properties.

Why do non-conforming loans have higher interest rates?

Non-conforming loans generally have higher interest rates because they cannot be sold to or guaranteed by Fannie Mae and Freddie Mac. This means the lender retains the full credit risk management of the loan, which is considered higher than that of a conforming loan.

Can I get a non-conforming loan with bad credit?

While non-conforming loans offer more flexibility than conforming loans, they typically require a strong credit score and robust financial profile, especially for jumbo loans, due to the increased risk for the lender. Some niche non-conforming products might cater to borrowers with unique credit situations, but usually with a significantly higher interest rate to offset the perceived risk.

Are all adjustable-rate mortgages (ARMs) non-conforming?

No, not all adjustable-rate mortgages (ARMs) are non-conforming. Many ARMs meet the criteria for Fannie Mae and Freddie Mac and are therefore conforming loans. However, some ARMs with features like interest-only periods or potential for negative amortization may be classified as non-conforming, as these characteristics can fall outside standard GSE guidelines.¹