In a recent post, we addressed some of the less obvious ways in which a lower interest rate environment is likely to impact an agency universe with such a large volume of loans that are still out-of-the-money to refinance. In this post, we turn our attention to non-QM loans, whose unique characteristics mean they will likely feel the coming rate cuts differently.

Understanding the Distinctive Prepayment Dynamics of Non-QM Loans

Non-QM loans cater to borrowers who do not meet the stringent criteria of traditional agency loans, often due to factors like non-standard income documentation, credit issues, or investment property financing. Non-QM loans generally carry higher interest rates, and, unlike their agency counterparts, many have prepayment penalties designed to protect lenders from early payoff risk. Non-QM loans are also more likely than agency loans to involve investment properties – and thus, the underlying mortgages are not subject to the same “ability to repay” constraints that apply to agency/QM loans.

All these factors play a role in forecasting prepay speeds.

As rates decline, the incentive for some non-QM borrowers to refinance should increase, but several unique factors will shape the extent to which borrowers respond to this incentive:

  1. Prepayment Penalties: Many non-QM loans, especially those structured as Debt Service Coverage Ratio (DSCR) loans for investment properties, include prepayment penalties that can deter refinancing despite a favorable rate environment. These penalties vary widely, from a fixed percentage over a set period to declining penalties over time. The economic calculus for borrowers will hinge on whether the potential savings from refinancing outweigh these penalties
  2. Diverse Loan Structures: The non-QM market includes a variety of loan products, such as 40-year terms, hybrid ARMs and loans with interest-only periods, reminiscent of the pre-2008 lending landscape. This diversity means that not all non-QM loans will see the same incentive to refinance and the slope of the mortgage curve will matter. For example, loans with higher rates are likely to exhibit a stronger refinance response, particularly as the shape of the mortgage rate curve plays a significant role, with hybrid ARMs resetting off short-term rates and 30-year fixed-rate mortgages being influenced by movements in the 10-year Treasury yield
  3. Interest Rate Spread Compression: Historically, the spread between non-QM and agency mortgage rates has varied significantly, ranging from 100 to 300 basis points. A narrowing of this spread, driven by falling rates, could heighten the refinance incentive for non-QM borrowers, leading to faster prepayment speeds. However, the extent of this spread compression is uncertain and will depend on broader market dynamics. Souring economic conditions, for example, would likely contribute to a widening of spreads.

Key Factors Influencing Non-QM Prepayment Speeds

Loan Characteristics and Documentation Types

Non-QM loans can vary significantly by documentation type, such as full documentation, bank statements, or DSCR. Historically, as illustrated in the following chart, full documentation loans have shown faster prepayment speeds, because these borrowers are closer to qualifying for agency refinancing options as rates drop.

S-Curves by Doc Type (Full vs. Alt. vs. Bank Statement vs. DSCR)

Unlike agency mortgages, which include a substantial volume of loans originated at much lower rates, the non-QM market predominantly consists of loans originated in the past few years when rates were already elevated. As a result, a larger portion of non-QM loans is closer to being “in the money” for refinancing. This distinction suggests that the non-QM sector may see a more pronounced increase in prepayment activity compared to agency loans, where the lock-in effect remains stronger.

S-Curve (line) vs UPB (bars) by Refi Incentive

Economic Sensitivity to Rate Moves

For many non-QM borrowers, the primary barrier to agency loan qualification—whether credit score, income documentation, or property type—remains static despite lower rates. Thus, while a rate cut could improve the appeal of refinancing into another non-QM product, it might not significantly shift these borrowers towards agency loans. However, as noted, those closer to the threshold of agency eligibility could still be enticed to refinance if the rate spread and penalty structures align favorably.

Conclusion

The coming interest rate cuts are poised to influence the non-QM market in unique ways, with prepayment speeds likely to increase as borrowers seek to capitalize on lower rates. However, the interplay of rate spreads, prepayment penalties, and diverse loan structures will create a complex landscape where not all non-QM loans will behave uniformly. For lenders and investors, understanding these nuances is crucial to accurately forecasting prepayment risk and managing portfolios in a changing rate environment.

As the market evolves, ongoing analysis and model updates will be essential to capturing the shifting dynamics within the non-QM space, ensuring that investors and traders are well-prepared for the impacts of the anticipated rate cuts. Contact us to learn how RiskSpan’s Edge Platform is helping a growing number of non-QM investors get loan-level insights like never before.