In the mortgage universe, there are three primary types of loans – VA loans, conventional loans, and FHA loans.
But what are the differences between the three types?
As basic home financing, VA, conventional and FHA mortgages serve the same basic purpose.
But there are enough differences between the three to make them each entirely different loan types. Knowing how each one functions can help you determine whether or not it’s the best financing option for you.
VA Loan vs. Traditional Loan – The Basics
There are significant similarities between VA loans and traditional, or conventional, mortgages. Both are designed primarily for 1 to 4 family owner-occupied properties.
And each provides first mortgages, for both purchases and refinances.
From the big picture standpoint, the main difference is that conventional financing is provided by the Federal National Mortgage Association, commonly known as “Fannie Mae” or FNMA, and the Federal Home Loan Mortgage Corporation, known as “Freddie Mac” or FHLMC.
Contrary to popular belief, VA loans are not provided directly by the Veterans Administration. They’re actually funded by the Government National Mortgage Association (GNMA), or “Ginnie Mae”.
They’re referred to as VA loans primarily because they’re insured by the Veterans Administration.
By contrast, conventional mortgages – when mortgage insurance is required – is provided by private mortgage insurance (PMI) companies.
Since VA loans are part of a US Government home financing program, the rules dictating the program are determined by the Veterans Administration.
Conventional mortgage rules are determined both by Fannie Mae and Freddie Mac, as well as by the private mortgage insurance companies.
Perhaps the biggest difference between the two loan types is that VA loans are available only to active-duty military and eligible veterans. Traditional loans, whether conventional or FHA, can be extended to anyone.
One of the biggest differences between VA loans and traditional loans is that VA loans are limited to owner-occupied properties only. Occupancy must be either by the veteran or by the veteran’s spouse.
Conventional mortgages are available to buyers or owners of vacation homes and investment properties, as well as owner-occupied homes. There is no specific occupancy requirement, however rules and guidelines for non-owner-occupied properties are more strict than they are for owner-occupied ones.
For example, in the case of a vacation home, conventional financing will require the borrower to either make a larger down payment or to have greater equity than would be the case with an owner-occupied property.
The restrictions with investment properties are even more extreme. Not only will a larger down payment or equity position be required, but specific methods will be used to recognize any rental income used to qualify for the loan.
The lender may even require the borrower to have a specific amount of cash reserves – in the form of liquid assets – after closing on the loan.
None of those issues apply with VA loans since non-owner-occupied properties are not permitted.
Mortgage loan limits for both VA and traditional mortgage loans are essentially the same. For 2019, the maximum loan amount for a single-family property in most markets is $484,350, up from $453,100 in 2018.
The limit rises to up to $726,525 in areas designated as high-cost housing areas. (The higher VA loan amounts are generally determined by county.)
For 2 to 4 unit properties, the maximum loan amounts are as follows:
- Two units: $620,200 (up to $930,300 in high cost areas)
- Three units: $749,650 (up to $1,124,475 in high cost areas)
- Two units: $931,600 (up to $1,397,400 in high cost areas)
If you exceed the limits above with a conventional loan, you may be able to qualify for what’s known as a jumbo mortgage. That’s any type of loan where the amount exceeds the conventional limits.
Jumbo loans are typically funded by banks and other financial institutions. As such they have their own rules and guidelines, which are generally more strict with regards to down payment, income, and credit requirements.
You can get a VA loan in excess of the published limits, but you must qualify based on income.
In addition, you’ll generally be required to make a down payment equal to 25% of the loan amount that exceeds the published limits.
For example, if you purchase a single-family home for $684,350, you’ll be required to make a down payment of $50,000. That’s equal to 25% of $200,000, which is the amount of the purchase price that exceeds the single-family loan limit in a non-high cost housing market.
Put another way, if the value of the property exceeds published loan limits for the county where it’s located, you probably won’t be eligible for 100% financing.
Interest Rates and Loan Fees
Contrary to popular belief, interest rates and fees for VA loans are usually comparable to those of traditional mortgages, including both conventional and FHA loans. However, in some cases, you may find there is a slight difference in mortgage rates. So it is a good idea to compare both VA Loan rates and conventional mortgage rates before locking in your loan.
In each case, there’s a base interest rate that’s adjusted for certain factors. Credit score and loan size are common adjustment factors that can result in higher rates.
But conventional loans will also make adjustments for other factors, such as the size of the down payment on a purchase, or equity in a refinance property.
Down Payment Requirements
This is an area where VA loans and traditional loans go their separate ways. One of the most typical features of a VA loan is that it offers 100% financing – translating into a zero down payment loan.
By contrast, FHA loans require a minimum down payment of 3.5%. And in certain circumstances, such as with a very low credit score, the down payment requirement may increase to 10%.
The typical minimum down payment on a conventional mortgage is 5%, though there are loan programs for first-time homebuyers allowing down payments as low as 3%.
However, due to borrower profile factors, like credit and income, a conventional mortgage may not be approved with a minimum down payment. The borrower may be required to make a larger down payment to qualify for the loan.
As mentioned above, the only time a down payment is required on a VA loan is when the loan will exceed published loan limits. But a veteran can avoid that outcome entirely by staying within the limits.
The minimum credit score requirement for conventional mortgages is 620. This is a requirement not only of Fannie Mae and Freddie Mac, but also of private mortgage insurance companies.
Credit score requirements for FHA mortgages are generally more flexible. You’ll typically need a credit score minimum of 580 to qualify for a down payment of 3.5%.
But if your score is below 580, a 10% down payment will be required. As well, many individual mortgage lenders may refuse to make a loan at all to a borrower with a credit score below 580.
Technically speaking, VA loans don’t have a credit score minimum. However, the borrower does need to have clean credit for at least the past 12 months, particularly for their rent or mortgage payment.
In addition, a minimum of two years must pass since the discharge of a chapter 7 bankruptcy, or a foreclosure, before they’ll be eligible for a VA loan. The borrower must show a clean credit history during that time.
If the foreclosure was on a VA loan, the waiting period extends to three years. Put another way, where credit is concerned, VA loans rely more on actual credit history than on a credit score.
But much like FHA loans, a lender may impose a minimum credit score, which typically will be either 580 or 620. Lenders do have the ability to impose such limits within the VA loan program.
Of all the requirements involved in getting a mortgage, income qualification is probably the one providing the most flexibility.
Income qualification starts with a debt-to-income ratio, commonly referred to as DTI. That’s your recurring monthly debts, divided by your stable monthly income.
DTI actually has two numbers. The first is your new house payment, divided by your stable monthly income.
The house payment is comprised of the principal and interest on the mortgage loan itself, property taxes, homeowner’s insurance, monthly mortgage insurance premiums, and any homeowner’s association dues, if required.
The total of this payment is frequently referred to as “PITI” – short for principal, interest, taxes, and insurance.
The second DTI ratio – which is usually the most important – takes into account your total recurring monthly debt, including your new PITI. It will add monthly credit card payments, car payments, and student loan payments, as well as other obligations, such as child support, alimony, or the negative cash flow on other real estate owned.
On conventional mortgages, the housing DTI is generally limited to 28%, while total DTI is 36%. However, these ratios are routinely exceeded, especially when the borrower makes a large down payment on the property, has excellent credit, large cash reserves after closing, or will be reducing their monthly house payment.
On FHA loans, the housing ratio is 31%, while total debt is 43%. Again, these ratios are often exceeded when compensating factors are present.
VA Loan Income Qualification
Income qualification for VA loans is different. There is no specific housing DTI, but the total DTI is usually limited to 41%. However, that limit is frequently exceeded with good compensating factors. Many lenders will go as high as 50%.
But what distinguishes VA loans from other loan types is that DTI isn’t the only income factor. VA loans also rely on what’s known as the residual income method. It calculates the amount of money available after paying your housing and other fixed payments.
It starts with your stable monthly income, then subtracts the new house payment, recurring monthly debts, income taxes, utilities and even an allowance for your household family size. The amount left over should be a positive number.
While it may seem VA loans have a higher income qualification standard, using two qualifying methods, the opposite is closer to the truth. A healthy residual income balance can be a justification for approving a loan with a DTI over 41%.
Mortgage Insurance Requirements
Mortgage insurance is one of the areas where VA loans make a near-complete departure from traditional loans, whether conventional or FHA.
On FHA loans, mortgage insurance is referred to as MIP, or mortgage insurance premium. It has two components, the upfront premium, and the monthly premium.
The upfront premium is 1.75% on purchases, and that amount is typically added on top of the base mortgage amount. Monthly MIP has a rate of 0.80%.
On a $200,000 mortgage, this would translate to a $1,600 annual premium or about $133 per month added to the monthly mortgage payment.
Conventional mortgages don’t have an upfront mortgage insurance premium. But monthly PMI applies on any loan with a down payment or equity of less than 20% of the property value.
The exact amount of the monthly PMI payment will depend on a number of factors, including your actual equity in the property and your credit score range.
For example, if you purchase a property with a 5% down payment, and you have a credit score of just over 700, the annual premium rate on a $200,000 loan will be 0.78%. That will result in an annual premium of $1,560, or a monthly premium of $130.
VA Mortgage Insurance – The VA Funding Fee
There is no monthly mortgage insurance premium on VA loans. There is only a one-time, upfront premium, referred to as the VA funding fee. However, it is also possible to have the funding fee waived if you have a VA Service-Connected Disability Rating.
The exact amount of the fee depends on the type of loan (purchase or refinance), and the type of veteran (regular military, or reserves or National Guard).
Purchases, 100% financing:
- Regular Military: 2.15% of the loan amount for first-time use, 3.3% for subsequent uses.
- Reserves/National Guard: 2.4% for first-time use, 3.3% for subsequent uses.
Cash-out refinances, regardless of equity:
- Regular Military: 2.15% for a first-time use, 3.3% for subsequent uses.
- Reserves/National Guard: 2.4% for first-time use, 3.3% for subsequent uses.
- Interest rate reduction refinance loans (IRRRLs): .50%, regardless of equity.
The funding fee is typically added to the loan amount, which means the veteran can conceivably owe more on the property than it’s worth.
Final Thoughts on VA Loans vs. Traditional Loans
As you can see from the information above, each of the three loan types has its own advantages and limitations.
But generally speaking, VA loans have the most advantages and the fewest limitations.
Consider yourself fortunate if you’re an eligible veteran or current member of the military.
The absence of a down payment requirement or monthly mortgage insurance premiums gives VA loans a serious advantage when it comes to acquiring or maintaining a home.