Understanding VA Mortgages and IRRRLs: Save Money with Your VA Benefits

Generally, homeownership is viewed as a cornerstone for building wealth. As World War II was coming to a close, millions of veterans were returning home to begin their civilian lives. The Servicemen’s Readjustment Act of 1944 was passed and included provisions for a loan guaranty to help returning veterans purchase a home. Over the years some details have changed but, fundamentally, the VA home loan program still exists to help veterans achieve home ownership.

What is the VA home loan program?

First, let’s clarify what the VA home loan program is not. It’s actually not a mortgage! Instead, the VA home loan program is backed by the Department of the VA. It’s a loan guaranty. It tells a lender that, in the event that the borrower fails to pay, the program will step in and repay a portion of the loan. 

Since there is less risk that the lender will lose all of its money, borrowing terms are often more favorable, particularly for borrowers who could not otherwise qualify for a mortgage. 

How do you earn eligibility for a VA Loan?

To be eligible for a VA loan you must serve for at least 90 continuous days on active duty. National Guard and Reserve members are eligible if they meet the active duty requirement or can earn eligibility by serving for 6 credible years. Even if you don’t meet the service requirements, there are some situations where you may still be eligible. In short, always ask if you’re eligible.

This is one benefit that most veterans are eligible to use.

How is a VA loan different from a conventional mortgage?

Since the VA backs the loan, interest rates might be lower than otherwise available for a given borrower. There is no requirement for private mortgage insurance (PMI), a downpayment may not be required, and credit standards could be lower. 

VA loans and conventional mortgages both, typically, have closing costs associated with them, but a VA loan may include a VA funding fee in closing costs. The borrower can pay the funding fee out of pocket or roll it into the mortgage.

What is the VA funding fee?

To help fund the cost of the VA home loan program, VA loans have a funding fee. The amount of the fee depends on a few factors such as whether it’s the first use of the program and amount of the down payment. The fee could be as high as 3.3% or as low as 1.25%

An important note is that the funding fee is waived if the veteran has a service-connected disability. This might be a key factor when considering the timing of your home purchase when transitioning from the military. For example, if you’re leaving active duty it might be worth delaying the purchase of your home until just after you separate. Then, if your VA claim results in finding any service-connected disability that’s backdated to your separation you could receive a refund of your funding fee. However, if you purchase the home just before leaving active duty, you would not receive a refund since you closed on your home before the effective date or your disability rating.  

What happens if interest rates fall after I close on my mortgage or if I need to refinance for another reason?

Sometimes it makes sense to refinance your mortgage. One of the most common reasons to refinance is because interest rates are lower than when you closed on your current mortgage. Just like conventional mortgages, borrowers are allowed to refinance their loan. In fact, there is a special process designed to make it easier, and less expensive, to refinance. The process is called the Interest Rate Reduction Refinance Loan (IRRRL) or “streamline refinance”.

As the “streamline refinance” moniker suggests, the process requires less paperwork, typically involves a lower funding fee (if required at all), and can be done without out of pocket costs.

How do I decide if refinancing is the right choice for me?

There are a variety of factors in play when deciding whether to refinance. But, generally, the primary factor is whether you can save money over the life of the loan. Saving money over the life of the loan is different than just reducing your mortgage payment. In some cases, that could be the primary driver for your decision but generally you really want to save money over the long term.  

In order to save money over the life of the loan, the interest rate of the new mortgage needs to be lower than the interest rate on your existing loan. AND, the interest rate of the new loan needs to be low enough that the cost to refinance can be recouped within a reasonable period of time (a good rule of thumb is within 24 months). 

For example, let’s pretend you have a $500,000 balance on your mortgage, that your current rate is 6.5% and that your mortgage payment is about $3,160 per month. Let’s pretend you can refinance your mortgage with a new rate of 6.4% and that it will cost $3,000 to do it. If you pay the $3,000 out of pocket, your new mortgage payment would be about $3128 per month.  That’s a savings of ($3160-$3128) $32 per month.  On a 30 years mortgage you would, technically, save money over the life of the loan because instead of paying a total of ($3160 * 360 months) $1,137,600 you would pay ($3128 * 360 + $3000) $1,129,080.

But how long does it take you to recoup the $3,000 that you paid to refinance? It would take about 93 months ($3000/ $32) or about 7.8 years. Will you still be living in the house in 7.8 years? Maybe. Maybe not.  In this case, it may not make sense to refinance just because the rate is lower.

But, let’s pretend the rate is meaningfully lower and the savings is $300 per month. You can recoup your closing costs within 10 months – it could make sense to refinance.

How often can you refinance?

Technically you can refinance as often as you wish. However, there are some timing rules associated with the streamlined process. You must wait at least 210 days from the date of your first payment on your current loan before you can refinance again.  

Wrapping Up

If you’re contemplating a home purchase or a refinance and aren’t sure how to get the most out of your VA home loan benefit, talk with a fee-only financial advisor.  They (probably) aren’t licensed to sell you a mortgage but they can help you understand the options, run the numbers, and, if desired, can connect you with a reputable mortgage broker.