We've covered in the past some of the ins and outs of qualifying for a home loan. Credit scores, debt to income ratios ... it's a pretty complex process. Adding to the confusion is the fact that there are many different types of mortgages for which a person might apply. Today, we’re going to cover a type of mortgage that is only offered to physicians and dentists, and it’s called the physician loan or the doctor loan. But before we start, let's establish a foundation on the ins and outs of mortgages in general.
What Is A Mortgage?
A mortgage is a loan you take out to purchase a home, and the payment for that mortgage can have a number of components. There is of course the payment for the loan itself, but that’s not all you have to pay when you own a home. You also must pay property taxes on your home, and you’re required to have insurance on your home as well. While you can pay your property taxes and homeowners insurance separately, many choose to have them all included in one payment. Lastly, and this is very important for the physician loan discussion, some people have an extra amount on their mortgage payment called PMI, or Private Mortgage Insurance.
What Is PMI?
PMI is insurance your lender takes out for themselves against your loan in case you default on your mortgage, but they make YOU pay for it! The cost of PMI can be around 0.5% to even 1% of the value of your loan, so for larger houses this can add up. On a $200,000 mortgage at 1%, this would add $2,000/year to your payments, or about $167/month. For homeowners whose adjusted gross income is less than $109,000, they can deduct all or a portion of their PMI payments on their tax returns. But as you can imagine, a fully practicing physician will likely make more than that, meaning they have this extra amount on their loan payment and can’t even deduct it on their taxes. So how do you avoid PMI? It’s all in how much money you paid when you got in the home.
Down Payment and Closing Costs
There are two items that must be paid before you get into your home. The first is closing costs, literally the costs of all the items that are needed to finalize the loan process. Closing costs can be around 2%-5% of the total loan, so sticking with our $200,000 mortgage that would mean about $4,000-$10,000 in closing costs. The second element of getting into a home is the down payment. While it varies by lender, many require home buyers to put down at least 20% of the value of the home, and those who don’t might still get their mortgage, but they’ll have PMI added to their payment. Now if you’re a young doc and you’ve been in residency for years making peanuts while paying back loans, it’s highly unlikely that you’ve been able to save up 20% of the value of the home you want to buy. The physician loan can help with that, but before we explain how, there’s one more element of the mortgage process we need to cover that could make things very difficult for physicians, and that’s debt to income ratio.
What is Debt to Income Ratio?
Debt to Income Ratio is the percentage of your monthly income that is taken up by your debt payments. For example, if you make $10,000/month and the total of all your monthly debt payments is $3,000, your debt to income ratio is 30%. Many lenders prefer that people applying for a home loan have a debt to income ratio in the mid-30s, but for conventional loans, there is a particular wrinkle in how they calculate debt to income ratio that overwhelmingly affects physicians, and it has to do with your student loan payments. If you’re a doctor, you know it is more than possible to leave residency and be searching for a home, all while owing $300,000-$400,000 in student loans. And you might be able to afford both because rather than using a conventional 20 or 30 year loan payment, where you pay the amount needed to fully pay off the loan in that period of time, you use an income-based payment, where your payment is based solely on a percentage of what you MAKE rather than what you owe (check out our series on federal student loan plans here). Under these plans, a person who might have to pay a few thousand dollars a month if they actually paid the loan off in full might only be paying a few hundred dollars a month based on the calculations for the income based plans. Unfortunately, for conventional loans, lenders often use the amount needed to pay the loan off in full when calculating your debt to income ratio, even though you’re likely paying nowhere near that amount. So while you might do your calculations including your loan payment and think you’re well within the parameters, the bank’s formula may look very different. BUT, now we can talk about how the physician loan can offer a lifeline to a doc who might not qualify under the parameters of a conventional loan.
So how is the physician loan different?
The first difference is with the down payment and closing costs. All lenders who use physician loans will still have to pay closing costs. But for the down payment, rather than having to put down 20% to avoid PMI, physician loans allow lenders to pay 0%-5% as their down payment and STILL avoid PMI. Now, it’s worth noting that these lenders are not THAT generous. To make up for the fact that they don’t get their PMI, lenders typically charge a little bit higher interest rate on physician loans. However, this doesn’t mean that taking the higher rate isn’t worth it. Remember that most physicians can’t deduct their PMI because they have adjust gross incomes over $109,000. But the interest you pay on a mortgage IS deductible as long as the value of your mortgage is below a certain amount. So while you may be paying more in interest, you could get a tax deduction, unlike in a conventional mortgage, where you either pay PMI without the tax deduction or find a way to put down 20% of the value of the home as a down payment.
The second difference in physician loans is how they treat income based student loan payments when it comes to your debt to income ratio. Whereas conventional loans use the amount needed to fully pay off the loan, which can push many physicians over the limit, many physician loans will accept your income-based payment when calculating your debt to income ratio. This makes your ratio look much more favorable to lenders when they’re deciding whether or not you qualify for a loan.
So, to compare, let’s say a couple with one physician in the home has an adjusted gross income of $250,000 and wants to buy a $300,000 home. If their lender requires a 20% down payment to avoid PMI, they would need to put down $60,000, and if they don’t they will not only have PMI, but won’t be able to deduct it because they make too much money. They will also have to pay closing costs. So let’s say they do pay the $60,000, leaving them with a mortgage of $240,000, and the closing costs are 2% of the mortgage amount, which would be $4,800. This would mean this couple had to pay $64,800 to get into their home with a conventional mortgage. And that’s IF they even qualify when doing the calculation for their debt to income ratio.
Conversely, let’s say that same lender has a physician loan that requires no down payment, only closing costs. For the same $300,000 home, they would pay nothing for a down payment and still avoid PMI. Now this would also mean their mortgage amount is the full $300,000, so if their closing costs are still 2% then that amount would be higher, $6,000. But, instead of the $64,800 it took under a conventional mortgage, this couple gets in the same house using a physician loan for $$6,000.
Is This A Good Option For Doctors?
There are two reasons that I think this could potentially be a great option for a lot of young physicians out there. The first is the age most physicians are when they get their first home and the value of that home. Because you’ve been in school and training so long, it’s not uncommon for physicians to not start really saving money until they’re in their mid-30s. While a home is great, you don’t want to put a tremendous amount of your savings down to purchase one when you’re already a decade behind other people when it comes to investing and putting money aside for retirement. The second reason is flexibility. In my experience, I don’t see many young physicians who are in their first homes for a long period of time. They move, or they make more income and want a bigger place, and when you put a lot of money down for a conventional mortgage, you’re also risking that your home value might not increase fast enough for you to recoup your costs before you move to another house. With the physician loan, you have less of an investment on the line, which in my opinion gives you more flexibility when a new opportunity presents itself and you have to or want to leave your home sooner than you'd planned.
The information presented is not intended as financial advice, and you are encouraged to seek such advice from your financial advisor.