If you decide to purchase a home or a rental property you’ll most likely take out a mortgage loan. Mortgage loans have either fixed or variable interest rates. Fixed rate mortgages obligate you to make constant monthly payments, typically over the course of 15 or 30 years. The monthly payments on variable rate mortgages, also known as adjustable rate mortgages, or ARMs, are tied to prevailing interest rates and can be expected to change over time. Variable rate loans can usually be converted into fixed rate loans.
Variable mortgage loans often offer low introductory rates, known as teaser rates, for a few years, and then adjust upward—sometimes dramatically. Low initial teaser rates may seem attractive, but once the low introductory rates expire some borrowers may be unable to keep up the much higher payments. Prior to the Subprime Crisis, many subprime (risky) loans were variable rate loans whose initially low introductory rates transformed into much higher rates after two years, forcing many borrowers into default.
Typically, to buy a property you’re required to provide a down-payment equivalent to 20% of a home’s value. You borrow the remaining 80% in the form of a mortgage loan.
Lenders evaluate the riskiness of a loan based on several factors, beginning with the loan-to-value ratio. If your down-payment is the standard twenty percent of the home’s value your loan-to-value ratio is eighty percent. If you default, the property value can decline by twenty percent and the lender can still recover its full loan amount by seizing your property and selling it. A low loan-to-value ratio is viewed more favorably by lenders because they have a larger buffer and face less risk. They may reward you for a larger down payment by offering a lower interest rate on your loan.
In contrast, borrowers who put less than 20% down on a home purchase generally must accept an extra monthly expense for Private Mortgage Insurance (PMI).
Private Mortgage Insurance (PMI)
PMI protects the lender in the event the borrower ends up in foreclosure and the value of the home is less than the outstanding loan amount. Typically, the borrower pays the PMI premiums annually, which range from 0.5 percent to 2.25 percent of the original loan amount. Borrowers can usually cancel PMI coverage and stop paying its premiums once their loan-to-value declines to eighty percent.
Lenders also look at a borrower’s indebtedness (for example, student loans) and assets. The ratio of debt to assets is referred to as the Leverage Ratio. Generally, the higher the ratio, the riskier the borrower. Borrowers with high leverage typically find it harder to qualify for a loan or may be required to pay a higher interest rate. Highly leveraged applicants may be denied credit.
Another measure lenders look at is the debt-to-income ratio. This measure aims to quantify the borrower’s ability to service debt. Generally, a person with a low ratio of debt to income can handle higher debt levels. A person with a high ratio is riskier. The latter may be charged higher rates, subject to stricter borrowing limits, or denied credit altogether.
The 30% Rule of Thumb
One rule of thumb is that a household should not spend more than 30% of monthly income on housing. If you own the home, the 30% limit includes principal, interest, taxes, utilities, maintenance, etc. If you’re a renter, the 30% limit includes monthly rent and tenant-paid utilities. Of course, where you live has a big impact on this rule’s relevance. If you live in New York City or San Francisco you may have to spend more than 40% of income on housing, whereas in a rural setting you may spend less than 20%.
Low- and Zero-Down Offers
Lenders know doctors have high earning capacity and statistically low default probabilities. For this reason, you may find banks offering special deals for doctors, including zero down-payment offers, PMI waivers, and ignoring existing student debt in debt-to-income calculations. To qualify, you may be required to show prior work experience or some proof of employment such as a copy of your employment contract.
There are downsides to these offers. The more of the purchase price you finance through borrowing, the larger your monthly mortgage payments. You’ll also end up paying more interest over the lifetime of the mortgage.
A zero down-payment offer means the loan-to-value ratio is one-hundred percent and the lender has no buffer in the event you default. The lender will likely protect itself by charging you a higher interest rate—which could mean higher interest rate charges for the next thirty years! According to Ivy et al. (2020)*, “Physician mortgage loans [zero-down, waived PMI] typically have approximately a 1/8 to 1% higher interest rate than a conventional 30-year home mortgage loan.” Even at the lower end of this range you could end up paying thousands of dollars more in interest over the lifetime of your loan.
The lesson here is that just because you’re given the opportunity to buy a home with zero money down, doesn’t mean you should take it. Lenders don’t make these offers as a favor to you—they make the offers because they stand to profit. And real estate agents encourage you to buy a larger, more expensive home—made possible using zero-down offers—so they can make a higher commission. The result is that agents and lenders make more money while you're stuck with a budget-busting monthly payment. Follow a responsible budgeting process (described in a separate chapter) to identify a reasonable monthly mortgage payment that allows you to live within your means, pay back student debt and invest for retirement.
If you qualify for Veterans Affairs (VA) benefits, there may be other lending or housing programs available to you. Check the government website at https://www.va.gov/.
Related Links: Mortgage Calculators
* Ivy A, Standiford K, Mizell J. Financial planning for colorectal surgeons. Seminars in Colon and Rectal Surgery. 2020;31(1):100713.
Buying vs. Renting
Historically, government tax policies and American cultural inclinations encouraged home ownership, while portraying renting as “throwing money away.” In the wake of the Subprime Crisis many people have revised their thinking about homeownership and opted for renting instead—a perfectly legitimate alternative
Benefits of home ownership include: the appeal of owning a tangible, physical asset you can see and touch, the long-term record of real estate as an appreciating asset—one that does reasonably well in inflationary periods, and potential tax deductions.
It’s easy to get caught up in home ownership euphoria. Yes, real estate investments have many positives, but you must be aware of the full picture before diving in.
First, you must decide whether you can afford to purchase a home:
Next, you must be sure you want to own a home. Here are some potential drawbacks to owning your own home:
As a renter you avoid these downsides. Renting for a few years gives you an opportunity to save up for a down payment and to make sure you pick the correct neighborhood for a future purchase. In hindsight, clearly more people should have opted to rent in the mid-2000s. Instead, numerous households took on unaffordable debt and lost their homes.
There are templates and calculators that can help you make the buy vs. rent decision. Two potential sources are: BankRate.com and nerdwallet.com.
As a rule of thumb, if you’re going to be living in a particular location for less than four years, you would most likely be better off renting rather than buying. This is primarily because of various fees and closing costs that you must pay to purchase a home.
Closing costs are between 2 to 5 percent of the purchase price of a home. Closing costs include expenditures on appraisals, title insurance, attorney fees, taxes, etc. By law, lenders must provide closing cost estimates to you within three days of receiving your loan application.
The lender may offer to waive some closing costs. But beware, sometimes the lender will make up for this concession by charging you a higher rate of interest, which can add up to much more than the closing costs over 30 years of mortgage payments.
With the four-year benchmark in mind, if you are a resident or fellow beginning a four-year program it may make sense for you to buy a home. It makes even more sense if there is a high probability that you’ll take a full-time position in the same location. One danger with buying a home upon arrival in a new city or town is that you may choose the wrong neighborhood. It can be a much better move to rent for a year and identify the best locations and properties. If you are unlikely to remain in the area and you have other significant financial obligations there’s nothing wrong with renting while you are still a trainee and directing any extra funds to paying off loans or investing for retirement.
If you do opt to purchase a home there’s one thing you can’t do—miss payments.
Implications of Missing a Mortgage Payment
Missing even a single mortgage payment is bad, because it could be setting you on a path to losing your home and all the money you’ve put into it. If you appear to be on the verge of missing a payment, let your lender know immediately. The lender can usually make arrangements for you to make up a monthly payment later instead of initiating proceedings that will hurt your credit rating.
But don’t miss another payment! Lenders may work with you once, but multiple occurrences will not be met with much sympathy. Because you don’t ever want to be in this situation, you must budget properly before purchasing a home. Be aware of all the costs of acquiring a home and that you’re certain you can afford the monthly payments and total cost of ownership. The best way to do this is to create and maintain a household budget. Budgeting is discussed in a later chapter.
Home Equity Line of Credit (HELOC)
A feature of property ownership is that you may be able to borrow money against the equity value in your home using a home equity line of credit, also known as a HELOC. A HELOC helps to mitigate real estate illiquidity by giving you access to cash. But you must set up the HELOC in advance so that it’s properly approved and ready to go when the need arises.
Setting up the line of credit may take a few weeks, but once set up, you can get the funds on very short notice. Usually, you’ll have checks or a credit card connected to the account. Any funds you withdraw will then require you to pay interest. When you pay off the loan your account once again goes into undrawn status. Usually, you pay a relatively small annual fee to keep the line of credit open.
In some cases your bank may offer to waive some of the costs of setting up a line of credit. But! And this is a big but, just because the bank is willing to give you a HELOC doesn’t mean you should get one. The collateral for the HELOC is your home. Failure to pay back the interest or principal could result in the lender foreclosing on, and ultimately seizing, your home. As always, think very carefully before taking on any credit obligations.