How the VA Guarantee Replaces Mortgage Insurance
When a veteran obtains a VA loan, the VA issues a guarantee to the lender covering a portion of the loan (up to 25% of the loan amount for full-entitlement borrowers). If the borrower defaults and the property is foreclosed, the VA pays the lender’s claim up to the guaranteed amount. This guarantee serves the same loss-mitigation function as FHA insurance or conventional PMI but without requiring the borrower to pay monthly premiums. The VA funding fee, paid once at origination, is the borrower’s contribution to the guarantee fund.
Because the VA’s guarantee is backed by the full faith and credit of the United States government, lenders view VA loans as extremely low-risk from a credit loss perspective. This is why VA loans consistently offer interest rates that are competitive with or lower than conventional rates, even for borrowers with moderate credit scores and zero down payment. The combination of government guarantee, no PMI, and competitive rates creates a cost structure that is difficult for any other program to match.
How the Funding Fee Is Determined and Paid
The VA funding fee is calculated as a percentage of the loan amount based on a matrix of factors. The primary variables are:
First Use vs. Subsequent Use: Veterans using their VA benefit for the first time pay lower fees than those using it a second or subsequent time. This distinction reflects the fact that the VA has already guaranteed a prior loan for that veteran.
Down Payment: A down payment of at least 5% reduces the funding fee, and a down payment of 10% or more reduces it further. The fee reduction incentivizes borrowers to put money down if they have the means to do so.
Service Category: Regular military (active duty and veterans) and Reserve/National Guard members pay different fee rates, with Reserve/Guard members paying slightly higher fees .
Exemptions: Disabled veterans, surviving spouses, and certain other categories are completely exempt from the funding fee. This exemption, combined with no PMI, means these borrowers can purchase a home with virtually no upfront costs beyond standard closing expenses.
The funding fee can be paid at closing or financed into the loan. Financing increases the loan balance; for example, a $350,000 loan with a 2.15% funding fee becomes $357,525 if financed. Borrowers with available funds may prefer to pay the fee in cash to keep the loan balance and monthly payment lower.
How Residual Income Is Calculated
The residual income calculation begins with the borrower’s gross monthly income and applies a series of deductions to arrive at the net income available after all obligations. The deductions include federal, state, and local income taxes (estimated), Social Security and Medicare taxes, the proposed mortgage payment (principal, interest, taxes, insurance, and any HOA fees), all other monthly debt obligations appearing on the credit report, an estimated maintenance and utilities allowance based on the property’s square footage (typically $0.14 per square foot) , and any child care costs or court-ordered obligations.
The remaining amount after these deductions is the residual income, which must meet or exceed the VA’s minimum threshold for the borrower’s region, family size, and loan amount. The four VA regions are Northeast, Midwest, South, and West, with the West requiring the highest residual income thresholds and the Midwest the lowest .
If the borrower’s residual income exceeds the minimum by 120% or more, it qualifies as a significant compensating factor that can support approval despite other marginal aspects of the file, such as a DTI ratio above 41%. The residual income test is a distinctive and practical safeguard that focuses on actual post-obligation cash flow rather than a simple ratio.
How Entitlement Restoration and Second-Use VA Loans Work
Veterans who have previously used their VA loan benefit can restore their entitlement and reuse it. Full restoration occurs when the prior VA loan is paid in full and the property securing it is no longer owned by the veteran. In this case, the veteran’s full entitlement is available for a new purchase, and the first-use funding fee rate applies.
A veteran may also use remaining (partial) entitlement to obtain a second VA loan while still holding the first. In this scenario, the available guaranty is reduced by the entitlement used on the existing loan, and the subsequent-use funding fee applies. The maximum guaranty for the second loan depends on the county loan limit and the amount of entitlement already committed. This provision allows veterans to relocate (such as a PCS move) without selling their current home and still use VA financing on the new residence .
Related topics include conventional loans explained, fha loans explained, usda loans explained, down payment requirements by loan type, and to choose the right loan program.