The Department of Veterans Affairs helps qualifying veterans (and others) with buying a first home. This help comes through the VA's Loan Guaranty Home Loan Program. This guide will explain:
- how home loans work generally, and
- how the VA Home Loan Program works
Buying a home is often the biggest financial commitment a person will ever make. Due to the high costs of purchasing a home, most buyers will need to borrow money. Some home sellers are willing to owner-finance the home. This means that the seller will accept monthly payments from the buyer, including an interest fee, until the full price of the home is paid off. But most sellers will want all of the money up front. Thus, the majority of home buyers will need to deal with a bank or other lending institution to finance their purchase. Understanding the terms used by banks can be the difference between an excellent or horrible investment.
Generally, a home loan from a bank works like this:
- The bank will examine your credit history, and your financial situation.
- If the bank decides that they want to loan to you, they will then pay the house seller the agreed upon amount.
- You will then be obligated to pay a monthly payment to the bank, including interest, until the full amount borrowed from the bank is repaid.
Banks are businesses. They are concerned with making a profit and ensuring that their investments (in this case your loan) are protected. This means that almost everything that a bank does will have to do with protecting itself against a default. A default is when an individual fails to make his required monthly loan payments. The bank will do several things to protect itself.
Credit History and Financials
Prior to giving you a home loan, a bank will examine your credit history to ensure that you are trustworthy and likely to pay your bills. The bank will also ensure that you have a steady and reliable stream of income (such as an established job, disability payments, social security, etc.). The bank also wants to see that your income is not overshadowed by your monthly bills. This is important to the bank because, historically, the more “extra” income that a borrower has after paying monthly bills, the less likely he is to default on his bank loan.
A bank will usually require that you put up some collateral. Collateral refers to something of value that you offer up to be taken by the bank if you default on your payments. Usually, the collateral required by the bank will be your new house itself because the bank will then be able to take the house and sell it to regain some of its money if you stop making payments.
A bank will often require that you pay for something called mortgage insurance. Banks usually require that you get this insurance if you take out a loan that covers more than 80% of the value of the home. So if you are able to make a large down payment (usually at least 20%) that brings the loan amount to below 80% of the value of the home, you may not have to pay mortgage insurance.
Under this plan, an insurance company will cover an agreed upon amount of the value of the house in the event of a default. Thus, the bank is able to protect itself from a default. If you stop paying your monthly payments and the bank is forced to take your house and sell it for less than they loaned you, any difference will be made up by the mortgage insurance. So, by requiring the insurance, the bank protects its investment.
For example, if the house is worth $100,000 and you have $25,000 in mortgage insurance and you default the bank will try to sell the house. If they sell the house for only $75,000 the insurance will pay them the remaining $25,000 to make up for their loss.
The interest rate you will pay on your home loan is determined by several factors. The bank will consider, among other things:
- the economy,
- your credit history,
- your income level,
- the amount of the loan,
- the length of the loan, and
- the type of the loan
Generally speaking, the more risky the loan is for the bank, the higher your interest rate will be. A higher interest rate makes up for the risks that the bank must take in giving a particular loan. Conversely, the bank will offer a lower interest rate on a less risky loan.
The total amount of money that you pay over time will largely be determined by your loan interest rate. The difference between a high and low interest rate could be thousands of dollars over the full term of the mortgage. Thus, you should pay very close attention to the type of interest rate being offered. Banks have come up with a whole range of different interest rate plans in an effort to be able to loan to a variety of different customers while keeping their risk low.
- Fixed Rate Mortgage: This means that whatever interest rate is decided upon will remain the same throughout the entire period of the loan. Fixed rates are usually a bit higher than the other rates because the bank is forced to bear the risk. If rates go up during the course of your loan, they lose out on getting a higher interest rate later on.
- Variable Rate Mortgage: A variable interest rate is one that may change over time. In the United States, these mortgages are usually known as Adjustable rate mortgages (ARMs) and are regulated by the government. ARMs have a reset dates - when the interest rate is recalculated. For example, a 5/1 ARM means that the interest rate will be fixed for the first five years, and then will reset annually. The new interest rate is calculated based on market conditions. Because banks are allowed to change your interest rate as market conditions change, ARM loans are usually offered at a low initial interest rate. The risk is that if interest rates go up, you may not be able to afford your payments.
- Interest Only Mortgage: This type of loan allows for the payment of interest only for a set number of years, usually 5 to 10 years. After the interest payment period is over, you'll start paying on the "principal" (the basic amount borrowed). The result of this is that the payments at the beginning of your mortgage period are much lower because they are just interest. This type of payment system is used by some people if they expect to have a much better job down the road. However, there is also a great danger associated with these mortgages because it is easy to find yourself unable to pay on the balance when the time comes. Interest Only Mortgages usually have higher interest rates and often are ARMs.
- Negative Amortization Mortgage: You may be offered this type of loan if you cannot make large upfront payments. The amount charged at the beginning of the loan is actually less than the total interest owed for that month. Thus, the total balance of the loan increases every month. There is usually a five (5) year limit to this plan so that you eventually have to pay down the balance. This type of mortgage is often used by a contractor who is rebuilding a property and plans to sell it within the next five years. If you are a first time home buyer, this probably isn’t the best option for you. The interest rate on a Negative Amortization is usually an ARM.
- Balloon Payment Mortgage: This type of mortgage allows for lower monthly payments, but requires a large “balloon” payment at the very end of the loan. Thus, your monthly payments may be less, but if you have not saved up enough money to pay the large balloon payment at the end, often $10,000 - $20,000 or more, you will default on your loan.
These are just a few of the loan types that are out there. Lenders are constantly coming up with new "mortgage products." The main message here is that you should pay very close attention to the details of any offer as it can seriously impact your ability to pay off the loan.
For example, imagine that the bank offered you a loan at 5.5% fixed or a loan at 4.0% variable. If the economy stayed the same or changed so that the normal interest rates went down, your choice to go with a variable rate at 4.0% would be sound. However, if the economy changed so that interest rates skyrocketed to 7%, the bank would adjust your interest rate under the variable system to 7%. Thus, it would have been better for you to take out a loan at 5.5% fixed.
Therefore, part of deciding whether to take a variable rate or not includes making predictions about where you think the economy is headed. But a fixed rate mortgage is usually the safest bet.
In addition to the interest rate offered by the bank, the "loan period" can have a powerful impact on your finances. Generally, the longer the repayment period of the loan, the lower the monthly payments will be. However, the longer the period of the loan, the more money you pay the bank by the end of the loan.
While mortgages can last for any time period, banks usually offer programs that allow for repayment over 10, 15, 20, or 30 years. The most common mortgage is the 30 year mortgage because the monthly payments are less. This means that if you make the agreed upon payment every month for the next 30 years, you will pay off the bank and own the house outright. When you take out a home loan, the bank will provide you with an "amortization schedule." This is a chart showing you what your payment will be every month, how much of that payment will go toward the balance of your loan, and how much will go toward interest. In the beginning, most of you monthly payment goes toward paying off interest. Later on the interest portion of your payment decreases and the portion going toward the balance (or "principal" increases.
For example, imagine that you wanted to buy a house for $150,000. You decide that you want to go with a 30 year mortgage and the bank offers you a 5.5% interest rate at $850 a month. (This is prinicipal and interest only; not including insurance costs or other add-ons.) Under this plan, you will have paid a total of $306,000 after 30 years, including a total of $156,000 in interest alone.
This same loan taken under a 20 year mortgage plan would result in a total payment of $247,000, including $97,000 in interest payments at a total payment of $1,000 a month. Likewise, under the 15 year plan, the total payment would be $220,000, including $70,000 in interest at a total payment of $1,200 a month. Thus, you can see that the length of the mortgage plan will have a big impact on the total amount of your payments.
Veterans can realize a great advantage through the VA home loan program. All that you need to utilize the program is a "certificate of eligibility." Here are the requirements.
Individual Eligibility Requirements
These people are eligible for the Home Loan Program. Each must follow the appropriate steps to gain their certificate of eligibility.
- Veterans: Veterans will need a copy of their DD Form 214 to apply.
- Active Duty Personnel: Active duty members on regular duty who have served for a minimum of 181 days are eligible. They will need a current statement of service showing their full name, social security number, date of birth, date of entry, duration of any lost time, and the name of the command providing information to apply. This statement must be signed by the adjutant, personnel office, or unit commander.
- Reservists/ National Guard members: Currently serving Guardsmen and Reservists will need a current statement of service showing their full name, social security number, date of birth, date of entry, duration of any lost time, and the name of the command providing information to apply. This statement must be signed by the adjutant, personnel office, or unit commander. A discharged Guardsman who has never served on active duty will need to provide a NGB Form 22 (Report of Separation and Record of Service) for each period of service, or a NGB Form 23 (Retirements Points Accounting) and proof of character of service. A discharged Selected Reservist who has never served on active duty will need a copy of their last annual retirement points statement and evidence of honorable service.
- Some surviving spouses: Surviving spouses of servicemembers who died on active duty and who are not receiving any Dependency and Indemnity Compensation (DIC) will need a DD Form 1300 (Report of Casualty) from the military and a copy of your marriage certificate. If you already receive DIC you will automatically qualify. Surviving spouses of a veteran who died as a result of military service and who are not receiving DIC will need a copy of the veteran’s DD Form 214, the veteran’s death certificate, and a marriage certificate. If you are already receiving DIC you should simply send a copy of your award letter.
Veterans, Active duty personnel, Reservists, and National Guardsmen can obtain their certificate of eligibility in one of three ways.
- Apply online.
- Apply through your lender, or
- Apply by mail using a VA Form 26-1880. You may call 1-888-244-6711 to have the VA mail a copy of VA Form 26-1880 to you if you are unable to print it out.
Mail the completed form to:
Department of Veterans Affairs
P.O. Box 20729
Winston-Salem, NC 27120
Qualifying surviving spouses must submit a VA Form 26-1817 and mail it to:
Department of Veterans Affairs
P.O. Box 20729
Winston-Salem, NC 27120
The Home Loan Program is available for use for the following eligible purposes:
- Buying a home
- Buying a townhouse or condo in a project approved by the VA
- Building a home
- Repairing, altering, or improving a home
- Simultaneously purchasing and improving a home
- Installing solar heating and/or cooling, or other energy efficient improvements in a home
- Buying a manufactured mobile home and/or lot
- Buying and improving a lot for a manufactured home which you already own and occupy
- Refinancing a manufactured home loan in order to acquire a lot
Minimum Property Requirements (MPR)
When you buy a home with a VA home loan, the property must meet certain standards, know as the Minimum Property Requirements (MPRs.) The MPRs are designed to protect people from buying a property that is not structurally sound, safe or sanitary. The VA determines whether a home qualifies by ensuring that it meets the local housing code, federal regulations and HUD requirements.
These requirements can mean that you will not be able to pruchase a home that needs work using a VA home loan.
The VA may provide an exception to the MPRs if the problem with the property is justified by conditions common to a certain part of the country, or where those conditions make compliance impossible or impractical. For example, the VA may allow for slightly more dampness in a home in Louisiana than it would in Arizona, since Louisiana is known to be a "wet" state. However, when the VA provides an exception to the MPRs, it is likely that it will lower the valuation of the property and you will receive less in loan money. This may require you to pay a higher down payment for a home requiring one or more exceptions to the MPRs.
Due to the MPRs, buying a home with a VA home loan can take a long time. Veterans may wait many months for the VA to sign off on the property. Homes in foreclosure and short sales may be unavailable for purchase with a VA home loan because the seller is unwilling or unable to spend money to get the property up to VA standards.
In addition to the above requirements, you must occupy or intend to occupy the property as your home within a reasonable period of time after closing the loan. You must also have enough income to meet the new mortgage payments on your home loan, after considering all your other financial obligations. You must also have a good credit record.
The VA Home Loan Program is designed to get favorable loan terms from a bank. The VA acts as a guarantor of your loan which means that the bank take on less risk. So the bank is willing to offer you a lower interest rate and more favorable mortgage terms. In the event that you default, the bank will be able to make a claim with the VA for a percentage of the default. This guarantee essentially stands in the place of mortgage insurance. For this reason, both you and your bank benefit from the VA program. From the bank's standpoint, a VA loan is a safer investment than most normal loans because they have the backing of the government. So banks will work to meet the VA's requirements. These requirements translate into favorable loan terms. For example, the VA will determine the reasonable value of the home prior to approving the loan. This provides you with a trustworthy appraisal of the home's value.
Here are some other benefits of the VA Home Loan Program.
The VA Home Loan Program will usually allow you to take a home loan without having to make a down payment. (However, some lenders will still require a down payment – often depending upon your credit worthiness.) Generally, the VA will guarantee a no down payment loan if the purchase price of the home is less than or equal to the reasonable value of the property (as determined by the VA). Also, the VA will require that the loan does not have graduated payment features (such as a negative amortization mortgage, or a balloon payment mortgage).
The VA does require some participants in the VA Home Loan program to pay a "funding fee." This fee is designed to offset some of the program costs to taxpayers. The funding fee varies depending on the loan being taken, the veteran’s service, and the amount of the down payment (if any) being paid. Go here for a table of the various funding fees (scroll down to near the bottom of the page).
The VA will make the final determination on who must pay the funding fee. However, the VA may waive the funding fee for those:
- those who are receiving service-connected disability payments from the VA,
- those entitled to receive service-connected disability, and
- surviving spouses of servicemembers who died in service or from a service-connected disability
Another feature of VA loans is that they set limitations on the closing costs. Closing costs include the fees that are required to finalize the sale, such as lawyer fees, bank fees, inspection fees, title fees, etc. The VA provides a list of permissible fees, and the seller is not permitted to charge you any fees beyond those listed.
NOTE: The VA has issued a special notice on lender fees for loans closed in the fall of 2011. For more information, check the VA website here.
A VA loan must have a freely negotiable fixed interest rate that is competitive with the market rates. This is a very important benefit because it helps you to get a lower fixed interest rate than you may otherwise be able to get with your credit rating. The total interest rate that you pay will have a big impact on the total amount that you pay for home.
A VA loan allows for extended repayment terms which keep the monthly payments on the home loan low. This allows you to buy a more expensive home while making low payments. However, if you use a long pay-back term, you will still pay more in the long run for your home than if you had a shorter loan term.
VA loans allow for a right to prepay without penalty. (At the same time, lenders may require that any prepayment be at least equal to one monthly installment of principle or $100, whichever is less.) This term is extremely important because it allows you to take a long amortization loan, thereby keeping your monthly payments low, while providing you with an opportunity to make extra principle-only payments. Thus, you can pay off the loan more quickly, if you are able, without having to pay the entire interest fee over the longer term.
The VA requires the builder to provide a warranty. The VA will help you obtain the builder's cooperation in the event that any construction problems arise.
Loss-mitigation refers to several different ways lenders help you to avoid losing your home before or during the foreclosure process. The VA provides strong incentives for lenders under the Loan Guarantee program to work with you to avoid foreclosure. In addition, the VA has specialized loan representatives who can help you work with your lender to solve problems. You can call a VA loan representative by dialing 1-877-827-3702. Below is a list of the specific loss-mitigation techniques that many VA will use to avoid foreclosing on your loan.
- Repayment Plans: Repayment plans are designed to help you pay back amounts that you owe in back mortgage payments. The goal is to get you to pay your normal mortgage payments again and set you up with a repayment plan to make up for the mortgage payments you have already missed. To be eligible, you must be able to show that you can afford the repayment plan.
- Special Forbearance: This is when the lender allows you to temporarily stop making payments on your mortgage with the promise that you will resume making payments at an agreed upon time in the future. Usually, you must be able to show the lender a guaranteed source of income that you are expecting, such as a new job, or a tax return in order to qualify.
- Loan Modification: This is when your lender of the VA changes the terms of your loan to help reduce some of the current financial pressure on you in order to help you get back to making mortgage payments. This may include building your missed payments into a new, longer loan.
- Compromise Sale: This option, also known as a "short sale," requires that you sell your home to a third party at a loss in order to generate money to pay down your VA loan. Often, this option will allow you to cover your loan and walk away without hurting your credit score. However, as you lose your home in this case, it should be considered only after options like Repayment Plans, Special Forbearances, and Loan Modifications.
- Deed-in-lieu of Foreclosure: This is a last resort option before foreclosure where you sign your deed over to the lender as payment of your debt. This allows you to keep your credit score intact but will result in you losing your home.
VA loans allow for "forbearance" on your loan payments if you are experiencing financial difficulties. This means that if you qualify, the bank will temporarily suspend payments on your home, without foreclosing, to give you time to accumulate more money or to sell the property.
In a normal mortgage, part of your monthly payment is for mortgage insurance. Again, this is required by banks to protect them against the risks of a default. However, since the VA is acting as a guarantor through the VA Home Loan Program, there is no need for mortgage insurance. As a result, your monthly payment will be significantly less. This will allow you to pay off your loan faster and reduce the total amount of money that you pay for the home. Thus, by guarantying your loan, the VA is putting thousands of dollars back in your pocket.
Detailed information about the program (.pdf file)