Veterans and active service members typically use their VA loan benefits to purchase homes. But, other mortgage options exist, as well. As such, we’ll use this article to outline the considerations of using VA loans vs conventional loans to buy a home.
Specifically, we’ll discuss the following:
- VA Loan Overview
- VA Loan Pros and Cons
- Conventional Loan Overview
- Conventional Loan Pros and Cons
- VA Loans vs Conventional Loans
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VA Loan Overview
The US Government created the original version of the VA loan program to provide troops returning from World War II an affordable home buying option. While the program has changed since then, it remains an outstanding mortgage option for veterans and active service members.
Currently, the Department of Veterans Affairs administers the VA loan. But, the Department doesn’t actually lend money. Instead, it guarantees a portion of every VA loan issued by VA-approved lenders (e.g. banks, credit unions, and mortgage companies). With this system, the VA will pay lenders a portion of outstanding VA loan balances if a borrower stops paying. This insurance significantly reduces risk for lenders, and it allows them to provide outstanding VA loan terms to eligible borrowers.
To qualify for the VA loan, veterans and active troops must meet certain minimum service requirements. Active troops must complete 90 continuous days of service to qualify. For veterans who served between August 2, 1990 and the present, you must meet one of the following service requirements to qualify:
- 24 continuous months, or
- The full period (at least 90 days) for which you were called or ordered to active duty, or
- At least 90 days if you were discharged for a hardship, a reduction in force, or for convenience of the government, or
- Less than 90 days if you were discharged for a service-connected disability
VA Loan Pros and Cons
As stated, the VA guarantee reduces risk for lenders. This reduced risk allows the following outstanding VA loan terms for eligible borrowers:
- No down payment required: Many conventional mortgages require a 20% down payment. On a $250,000 home purchase, this means borrowers would need to come up with $50,000 cash ($250,000 x 20%) – plus closing costs – to secure a loan. VA loan buyers just need to bring closing costs to the table, significantly reducing the out-of-pocket cash requirements for a loan.
- No private mortgage insurance (PMI) required: If borrowers using a conventional loan use less than a 20% down payment, they need to pay PMI. This insurance protects lenders in case of borrower default, and it can add around $100 per month to your mortgage payment. Even though VA loan borrowers put 0% down, they do not need to pay PMI.
- Lower interest rates: Due to both the VA guarantee and lower default rates for VA loan borrowers, these loan products generally offer lower interest rates than conventional loans. According to mortgage processor Ellie Mae, VA loans currently average around a quarter percentage point lower than conventional rates. On a $250,000 loan, that creates a $34/month difference between 3% and 2.75% rates, or just over $400/year that VA loan borrowers would save.
- Streamlined refinancing option via the Interest Rate Reduction Refinance Loan (IRRRL): VA loan borrowers also have access to the IRRRL program, a quick and easy way to refinance into a lower interest rate. With this program, borrowers typically do not need to go through the normal appraisal, underwriting, and credit check process required for a refinance, making it an appealing option.
Despite these outstanding benefits, the VA loan also has some associated disadvantages. Borrowers should consider the below cons to the VA loan before deciding on a loan product:
- Occupancy requirements: The VA loan program exists to promote homeownership – not investing or vacation homes. Consequently, borrowers generally need to occupy new homes within 60 days of closing for at least a year. This means you cannot use the VA loan for vacation homes or purely investment properties.
- VA appraisal and MPRs: Due to its homeownership mission, the VA requires that homes purchased with a VA loan be safe, sound, and sanitary. To enforce this, borrowers must complete a VA appraisal. In addition to confirming the property’s value, this also acts like an “inspection, light.” Appraisers highlight any issues with the VA’s property standards, known as Minimum Property Requirements (MPRs). If a VA appraisal report includes MPR violations, the VA will not approve a loan until they’re resolved.
- VA loan funding fee: To offset the program’s costs, the VA requires a funding fee for VA loans. This is a one-time fee most borrowers must pay at closing, and it ranges from 1.4% to 3.6% of the loan amount. On a $250,000 loan, this is an additional $3,500 to $9,000 borrowers need to pay.
- Entitlement/use limits: The VA loan also has use limits. Eligible borrowers have a certain dollar value of entitlement for the loan program, and they cannot use it over and over. While the details get complicated for using the VA loan multiple times, the big takeaway is that the program does impose limits on how many times borrowers can use a VA loan.
While the details get complicated for using the VA loan multiple times, the big takeaway is that the program does impose limits on how many times borrowers can use a VA loan.
Conventional Loan Overview
When shopping for a home loan, buyers will likely encounter the term conventional loan. Simply put, a conventional loan is a mortgage that is not guaranteed by the federal government. Whereas the government insures VA loans, it does not insure conventional mortgage loans.
On the one hand, this lack of government backing increases risk to lenders. But, it also provides lenders more flexibility in structuring a conventional loan to meet the needs of a particular borrower and situation. In the next section, we’ll outline how these different considerations create pros and cons to using conventional loans.
Conventional Loan Pros and Cons
The major advantages to a conventional loan include:
- Available for investment properties: Whereas buyers can only use a VA loan to purchase a primary residence, you can use a conventional loan to buy second homes and investment properties, too. This provides borrowers tremendous flexibility in building a real estate portfolio outside of a primary residence.
- Multiple use option: As discussed, the VA loan program has limits on A) how many times it can be used, and B) the dollar amount that the VA will insure. Conversely, buyers can use conventional loans as many times as they’d like. But, it’s important to note that these loans generally must still comply with loan amount limits outlined by FHFA, the Federal Housing Finance Administration.
- No service requirements: Unfortunately, not all veterans qualify for the VA loan. On the other hand, conventional loans have no service requirements. This means that, if you don’t qualify for a VA loan for some reason, conventional loans offer a mortgage alternative.
Buyers also need to consider the disadvantages of conventional loans. Accordingly, here are some of the major cons:
- Down payment required: Generally, conventional loans require a 20% down payment. Coming up with that much cash can be an insurmountable obstacle for many borrowers. However, some lenders will provide conventional loans with as little as 3% down – better than 20% but still more than 0% down with a VA loan. But, putting down less than 20% with a conventional loan leads directly into the next drawback to these loans.
- PMI required: If a borrower places less than 20% down on a conventional loan, he or she will need to pay private mortgage insurance or PMI. Due to the fact that these loans have no government backing, PMI serves as a way to offset risk of default. And, it can add around $100 to monthly mortgage payments. In addition to this simply costing borrowers more, it also reduces their overall purchasing power. That is, when you include PMI in your future debt-to-income ratio, you’ll qualify for a smaller loan amount.
- Stricter qualification criteria: Due to the lack of federal backing, conventional loans typically have far stricter qualification criteria than VA loans. Borrowers likely need higher credit scores and lower debt-to-income ratios to qualify for one of these loans.
VA Loans vs Conventional Loans
For eligible borrowers looking to buy a primary home, the VA loan generally makes the most sense. The 0% down payment and low-interest characteristics just make this an incredible loan product. But, for veterans or active service members looking for more flexibility, conventional loans can be a solid alternative to the VA loan program. Accordingly, borrowers need to look at their unique situations and the above pros/cons of each loan program to determine the best option.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.
