Why the VA Does Not Require a Down Payment
This is a common question about the VA loan program because it seems too good to be true – “I can get a home loan without making any down payment when normally you have to make a 20% down payment? Yeah, right…” If you don’t know much about the VA loan program, that might even sound like a scam. It’s not. You really don’t have to make a down payment if you get a VA loan. However, that doesn’t mean that no money will be due at the time of closing on a VA loan. We’ll go into that as well as explaining the numbers behind why the VA loan program doesn’t require any down payments.
You’ll Still Have Money Due at Closing
“No down payment” is often confused with “No money down”, which is something different. While you can have a true no-money-down VA loan, that’s usually only available as a refinance by using the VA streamline option. The only other way to get a no-money-down VA loan is if the lender chooses to offer one, which will only be done if the money is being made up in some other way such as a higher interest rate. The down payment goes towards paying down the principal balance on the home, and it’s important to lenders because they want the object securing the loan to be worth more than the loan is being made for. Closing costs are different; closing costs are the fees and charges associated with getting a home loan. The VA does not allow closing costs to be rolled into the loan amount unless it’s a streamline refinance, so you’ll be looking at paying a few thousand dollars upfront on a VA loan even if you’re not making a down payment. Part of closing costs is the VA Funding Fee, which can be rolled into the loan amount if you would like, or you can pay it upfront as well. Many veterans are exempt from the Funding Fee, so it’s worth checking to see if you might be as well.
So Why No Down Payment?
As we touched on above, the lender needs to have a reasonable assurance that they will get their money back, and preferably a healthy return on their investment. One of the most important ways they do that is by requiring at least a 20% down payment on the house or the borrower purchase mortgage insurance. The reason why is because the house is the security for the loan; in other words, if you default on your loan, the lender takes the house as compensation. In a scenario where 20% of the value of the house has been paid off, the lender needing to sell the home at 85% of its fair market value in order to get rid of it quickly is not a big deal; they still get a small return on their investment. The last thing a lender wants is to make a loan for $100,000, only get $5,000 back from the borrower before they default, and then only be able to sell the home for $80,000, because that means the lender loses $15,000 on the transaction. In that same scenario, if the borrower had made a 20% down payment ($20,000), then paid $5,000 before defaulting, and the lender could only sell the house for $80,000, the lender gains the $5,000 that the borrower paid.
It may seem odd that the VA loan program lacks this protection, and if it really did it would be odd indeed. However, the VA loan program has its own protection called the VA Guarantee, and it is designed to eliminate the need for the borrower to make a down payment. Borrowers are still able to make a down payment if they wish and are encouraged to do so if they can afford it, but the Guarantee takes care of the minimum requirements that lenders need in order to be willing to make loans. The VA guarantees 25% of the loan amount to the lender when the loan is made. In other words, if the borrower defaults on the loan, the VA will pay up to 25% of the loan amount to the lender on their behalf. This puts the lender on even better ground than a 20% down payment and makes it even more likely that they’ll be able to at least break even and even turn a small profit on the transaction. Obviously not nearly as much as they would if the borrower had not defaulted, but enough that the risk is sufficiently mitigated.
Even though the Guarantee is paid to the lender when it’s used, it’s in place to help borrowers by eliminating the need for a down payment and opening up homeownership to more veterans sooner.