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Home Buying

What Is a VA Loan and How Does It Work?

What Is a VA Loan and How Does It Work?

8 Minute Read

Reaching the point in your life when you’re able to buy a home is hard work. And if you’re a veteran or serving in the military it can be more of a challenge compared to folks who are not.  

So what are your options if you’re a veteran and want to buy a home? Well, there’s one mortgage option specifically for veterans: the VA loan.

Let’s take a closer look at how a VA loan works and if it’s your best option when you’re about to jump into the real estate market.

What Is a VA Loan?

A VA loan is a mortgage loan that’s issued by private lenders and backed by the U.S. Department of Veterans Affairs. It helps U.S. veterans, active duty service members, and widowed military spouses buy a home.

VA loans were introduced as part of the GI Bill in 1944, but they’ve become increasingly popular in recent years. In the first quarter of 2019, 8% of home purchases were made with a VA loan.1 This type of loan is an attractive option because it’s pretty easy to qualify for and doesn’t require a down payment.

How Does a VA Loan Work?

VA home loans are one of the two nonconventional (or government) loans available today. They don’t work exactly like a regular mortgage you get from a bank because VA loans are specifically guaranteed by the government.

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This just means the government will agree to repay a portion of the loan to the bank if you don’t make your payments (default) or if you face losing your home (foreclosure).

Since the banks assume less risk compared to a conventional loan, VA loans are relatively easy to get. In 2018, the VA guaranteed 610,513 purchase and refinance loans.2

What Are VA Loan Requirements?

In order to get this loan when you're looking to buy a home, military personnel have to meet the VA’s specific service requirements.

 Generally, you’re eligible if you fall into one of these three categories:

  • You’re an active duty service member or an honorably discharged veteran who has 90 consecutive days of active service during wartime or 181 days of active service during peacetime.
  • You have served more than six years in the National Guard or the Selected Reserve.
  • You’re the spouse of a service member who died in the line of duty. 3

If you were to go through the application process, you would need a Certificate of Eligibility (COE) to show mortgage lenders that you qualify for a VA loan.4 You can apply for a COE through the VA website, by mail, or through your lender.

What Are VA Loan Benefits?

Here are some of the key features and benefits of a VA loan:

  1. You can buy a home with no down payment. VA loans are one of the last zero-down home loans available today. In 2018, around 50% of homes bought using a VA loan were bought with zero down payment.5

  2. There is no limit to the amount you can borrow on a VA loan, but there is a limit to the amount of liability the VA takes on. For 2019, the VA will guarantee a maximum of 25% (up to $121,087) of a home loan amount, which corresponds to a maximum loan of $484,350.6 Anything beyond that won’t be guaranteed by the VA. Sound dangerous? It can be!

  3. You won’t have to pay Private Mortgage Insurance (PMI). Since the loans are backed by the government, you can kiss PMI goodbye! PMI can range from 0.5% to 2.25% of your loan. So for a $200,000 loan, if your PMI rate was 1% that would mean an additional $166 to your mortgage payment each month!

  4. There’s no minimum credit score requirement. But lenders typically still look for borrowers with a credit score of 620 or higher. Although we believe your ideal credit score would be zero—because that means you have no debt!­—be aware that no credit score might put lenders on edge when it comes to giving you a loan.

  5. The VA offers assistance for struggling borrowers facing a potential foreclosure. The agency’s loan technicians can negotiate with lenders on behalf of borrowers who are having trouble making mortgage payments.

  6. There is no prepayment penalty. This means you won’t be fined if you pay off your loan early.

  7. You don’t need to be a first-time home buyer in order to get a VA loan. As long as you pay it off each time, you can use the benefit again and again.

  8. Bankruptcy and foreclosure won’t permanently affect your chances. If you’ve filed for bankruptcy or gone through a foreclosure, you can still qualify for a VA loan after two years have passed from the date of the bankruptcy or foreclosure.

What Are the Drawbacks of a VA Loan?

This all sounds great so far, right? But if you dig a little deeper, you’ll find some serious problems with this type of loan.

  1. The zero down payment leaves you vulnerable. A small shift in the housing market might leave you owing more on your home than its market value! That means you could get stuck with the home until the market recovers or take a financial loss if you have to sell the house in a hurry.

  2. You’re required to pay a VA loan funding fee between 1.25% and 3.3% of the loan amount.7 On a $300,000 loan, that fee can be anywhere from $3,750 to $9,900. And the fee is usually included in the loan, so it increases your monthly payment and adds to the interest you pay over the life of the loan. Plus, you might need to factor in origination fees from the lender. Yikes!

  3. The lower interest rates on VA loans are deceptive. While interest rates for 30-year VA loans are usually equal to or slightly lower than 30-year conventional fixed-rate loans, neither loan is a good option. Both will end up costing you much more in interest over the life of the loan than their 15-year counterparts. Plus, you’re more likely to get a lower interest rate on a 15-year fixed-rate conventional loan than on a 15-year VA loan. We can prove it.

  4. A VA loan can only be used to buy or build a primary residence or to refinance an existing loan. So you can forget trying to buy an investment property or vacation home with one. (Besides, using a loan to buy an investment property or vacation home instead of 100% cash is always a bad idea because it means more debt.)

  5. Only certain types of properties are eligible for a VA loan. Vacant land and co-ops don’t qualify. Other types of properties are up to the lender’s approval.

Is a VA Loan Worth It?

If you stack up a VA loan against a conventional mortgage, you’ll see that despite the benefits, when it comes to the cold hard cash, you’re best going with a conventional loan!

You’d have a better interest rate at around 3.6%, and you would also have no PMI.8 And you’d really see the savings when you looked at the interest paid over the life of the loan.

So, what if you decided to save up a 20% down payment on a $200,000 home and went with a 15-year fixed-rate conventional mortgage instead?

Let’s compare the numbers. We’ll use a current interest rate on a 15-year VA loan of around the 4% mark.9

DESCRIPTION 15-YEAR VA LOAN 15-YEAR FIXED RATE
Cost of Home $200,000 $200,000
Down Payment $0 $40,000
Funding Fee $4,300 $0
Total Loan Amount $204,300 $160,000
Interest Rate Over 15-Year Term $67,713 $48,156
Total Cost of Loan $272,013 $208,156

 

With a 15-year fixed-rate conventional loan, your total interest paid is $48,156—that’s almost $20,000 less than what you would pay in the VA loan example!

When you factor in the loan amount, the funding fee, and the total interest paid, the entire cost of the VA loan is $272,013. So you’re paying more over the course of the 15-year term compared to a conventional mortgage. Think of what you could do with all the money you’d save!

The bottom line is this: VA loans are usually one of the most expensive ways to buy a home. If you have to take out a loan in order to buy a home, go with a 15-year fixed-rate conventional mortgage with a 20% down payment to avoid paying PMI. Outside of buying your home with cash, it’s the best way to go.

If you’re looking for an experienced lender who will help answer all your mortgage questions and equip you to make the best decision for you and your family, check out Churchill Mortgage. For more than 25 years, their mortgage experts have coached hundreds of thousands of people on how to buy a home the right way.

 

*interest rates updated July 2019

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