Many first time veteran home buyers find themselves at a loss as they negotiate the loan process. I’ve created a comprehensive, yet (hopefully) easy to follow overview of the major terms and concepts you many encounter.
LOAN TYPES
There are two basic loan types – VA Fixed Rate mortgages and VA Adjustable Rate Mortgages or VA HYBRID ARM’s. VA Fixed Rate mortgages are fixed for the entire term of the loan and are the most secure loans. The term can be anywhere from 10-50 years depending on the loan program but 95% of the time are fixed for a 30 year term. These are best for veterans on fixed incomes and for veterans who plan on being in a property for either an extended or indeterminate amount of time and have no plans to refinance.
Since most veterans know that they will either sell or refinance their home well before end of the 30 years, many individuals choose adjustable rate mortgages. VA HYBRID ARMs can come in a variety of terms, depending on the loan product but are for the most part also based on 30 year terms. However, VA HYBRID ARMs have an introductory fixed rate period ranging from 3-5 years at a lower rate than those of a 30 year fixed loan. In exchange for the benefit of a lower interest rate, once the fixed rate period ends the loan will adjust to the current market conditions of that time.
It is a common misconception that when the Fixed rate period is up the loan rate will automatically increase. The loan will adjust according to the rate of the 1 year Constant Maturity Treasury Index (1yr CMT) + a fixed margin (usually 1.75-2.25%) which is determined at the inception of the loan. Let’s you had a 5 year VA HYBRID ARM at 7.5% with a margin of 2%. When the Fixed rate period is up after 5 years, if the 1yr CMT was at 4% then the interest rate on the loan would actually drop to 6%. Conversely, if the 1yr CMT at that time was higher, say at 6%, the rate would go up to 8%. Regardless what the 1yr CMT is at when the VA Fixed Rate ends, all VA HYBRID ARM’s have built in rate adjustment caps that limit how much the rate can change each month, year, and over the remaining life of the loan.
VA HYBRID ARM’s and VA Fixed Rate loans refer only to the interest rate on a loan. The terms Amortization and Interest Only refer to the payment schedulebased on this rate. Both VA HYBRID ARMs and VA Fixed Rate Loans are amortizing loans, although I will cover interest only loans as well to be thorough.
AMORTIZATION TYPES
Amortization refers to (with regard to mortgages) the repayment of the balance of the principle amount borrowed over a specific term. As mentioned earlier, loans have many terms and can be amortized over any of them. The key to understanding amortization is that it refers to a loan that is being repaid over the term of the loan. Banks “front end load” their loans in order to maximize their interest return. At the start of the loan, the bank calculates how much interest the rate they have locked you at will generate for them across the entire amount of the loan. When they receive your monthly payment, instead of equally distributing the payment to the interest due and toward reducing your balance, banks load the majority of the interest owed over the life of the loan into the first 10 years. Within the first year of a 30 year loan, the vast majority of the payment is going to pay the interest on the loan with very little actually going to pay down your principle balance. In the last year of the loan then, the majority of the payment will be going to pay down the balance, having paid the bulk of the interest calculated over 30 years in the first 10.
Interest Only loans are simply loans that do not amortize for a fixed period of time. On a 30 year interest only loan with a 10year interest only period, you will only be required to pay the interest due on the loan for the first 10 years. You will make no contribution toward principle. The interest you pay each month for the first 10 years is simple interest calculated by multiplying the balance (e.g. $100,000) times the interest rate (e.g. 6%) divided by the 12 months of the year. ($100,000 x .06 = $6000 , $6000 / 12 = $500+TI per month monthly payment for the first 10 years) By contrast, a $100,000 30 yr VA Fixed Rate amortized mortgage at 6% would be $599.55. Sure you might not be paying down your balance with an interest only loan but consider the following – you could take the $99.55 per month you were saving by not choosing an amortizing loan and:
- Put it toward paying down higher interest rate credit card debt
- Put it into an 6 month CD that would roll over every six months with compound interest taking advantage of rates as they rise. By doing this you would essentially be “hedging” the market against rising rates.
Putting money toward your home is beneficial only if it is contributing to a lower payment. Many veterans believe the interest they pay over the life of the loan reduces as their balance does over time. This is not true. It only appears that way. Because of the way loans are structured, the amount of interest you pay over the life of the loan is based of the original NOTE amount or principle balance. This interest you actually pay is the “front-end loaded” interest calculated on this original amount. So this means the only way you will lower your payment on most mortgages is by refinancing and paying off a portion of the remaining balance owed in a lump sum, thereby reducing your future payments on the new loan with a smaller balance and NOTE amount. By putting your savings away on an interest only loan as described in the 6 month CD example, you could actually pay down your balance faster than an amortizing loan of equal rate. Whenever you refinance, simply take the amount saved by making the I/O payment + the interest you have earned on in and use it to pay down your remaining balance. Putting money toward the equity in your home isn’t really safe anyway. Imagine if you took the $99.55 per month saved and put it toward your balance each month. If the property depreciates, that money is gone. If you had been saving it in a risk free, interest bearing investment, you not only have the money you would have lost but all of the interest earned as well.
CLOSING COSTS
The amount of VA loan closing costs you pay will be directly proportional to what rate you decide on. The general rule is: The higher the VA interest rate, the more projected interest the bank will make on you, the more flexibility the bank has to cover and or waive closing costs. You can choose to lock into rates even below prime if you choose to, but the bank will ask you to pony up with a commensurate amount of prepaid interest to “buy-down” your interest rate. It follows then that these fees are sometimes called “discount points”.
CONCLUSION
I hope this has been a helpful overview of the loan process and some of the key terms you may encounter. Feel free to check out some of my other posts (Linked Below) on specific VA loan products including the VA Hybrid ARM.
http://www.lowvarates.com/va-loan-blog/how-about-the-va-hybrid-arm/
http://www.lowvarates.com/va-loan-blog/veterans-need-to-take-advantage-of-the-va-hybrid-loan/
http://vimeo.com/10101207
Feel free to contact me any time with questions:
James Shergill
888-657-2848 ext 252 Toll Free Office Line
650-605-3638 Mobile
