It’s home-buying season, and selecting a mortgage can be daunting. Understanding the terms of the mortgage, the total cost, estimated property taxes and insurance, and the bottom line on a month-to-month expense can be a lot to take in. For many individuals, utilizing a mortgage to purchase a home can lead to months of underwriting (having the lender analyze your personal situation to approve the loan), painful discovery and disclosure of financial documents, and consistently changing deadlines. The purpose behind this process is to prove that due diligence is completed thoroughly because the mortgage originator will likely sell the mortgage to a servicer after the mortgage is approved.
When a mortgage is sold to a servicer, the mortgagee (or person who purchased the house) doesn’t choose which bank purchases the mortgage. The mortgagee is then involuntarily exposed to a new financial institution, and some mortgages are even sold to individual and institutional investors without knowledge or consent. This process isn’t necessarily alarming, but it seems unfair to be “sold” a mortgage without service after the purchase. What’s even more unfair is the fact that PMI – or Private Mortgage Insurance – is paid by the mortgagee to protect the financial institution if the mortgagee defaults on the loan. The financial institution should be the one to shoulder that insurance! (But I digress…)
There is a different kind of mortgage available to physicians, called a “Physician Mortgage” (creative name, right?). A physician mortgage generally forgoes PMI altogether, and this mortgage isn’t sold to a servicer; instead, the mortgage is serviced by the original lender. The fact that the mortgage isn’t sold to a third party paves the way for the financial institution to make its own rules behind issuing the mortgage. This is what ultimately determines the mortgage being a “physician mortgage”: the loan is originated and serviced by the same institution. Since the purpose of the lengthy mortgage underwriting process is to sell the mortgage, the physician mortgage forgoes these requirements and streamlines much of the underwriting requirements and eases some of the financial requirements to obtain a mortgage; therefore, the requirements of a physician mortgage aren’t standardized, so the rules are determined on a bank-by-bank basis.
The term “physician mortgage” is not an official term with specific rules required for all institutions to follow. One institution’s physician mortgage might have completely different rules than another’s. Each institution creates its own privately held set of systems to align with its program. Most physician mortgages offer 100% financing with low costs of mortgage origination, and all that’s required is an executed job contract, even if that contract begins at a future date (such as residents and fellows).
This sounds great, right? There must be a catch, right? Yes and no. The physician mortgage makes it easier, and oftentimes, cheaper to obtain a mortgage, but it can result in a more expensive mortgage. Not necessarily in all cases (since each institution has its own rules), using a physician mortgage can result in a slightly higher interest rate. Being high wage earners and integrated within the community, a bank has incentives to keep physicians around as customers; however, cutting corners on underwriting requirements and offering mortgages to residents can be a little risky. As such, there is sometimes an interest rate premium on physician mortgages. Normally this interest rate isn’t significant – maybe 0.25% to 0.50% or so. To give some perspective on this, a $500,000 30-year fixed mortgage with a 0.50% interest rate premium will add about $100 to the monthly payment.
There’s another possible downfall to physician mortgages, and it’s this: medical residents are given easy access to inflated mortgages before their first paychecks are even issued (signed employment contract but still in residency). Some banks will even preapprove some 40% or more of gross pay for a mortgage. To better understand the implications of this, 40% of a $200,000 income dedicated to a mortgage would lead to $1,350,000 30-year mortgage, assuming a 4% interest rate! While it’s great to have money easily accessible, I suggest getting your financial advisor (like me!) involved to better understand how much mortgage you should consider before you even start looking for houses.
Like everything else with physician mortgages, the program varies from bank to bank, but the available mortgage options can be limited. When you apply for an FHA mortgage or a conventional mortgage, you can opt for a 30-year fixed mortgage. While some do, few physician mortgage programs offer a 30-year fixed term.
Many physician mortgage programs offer an Adjustable-Rate Mortgage, often called an ARM. Most ARMs are based on 30-year mortgages, but they aren’t fixed for 30 years. Whenever you see the letters ARM in a mortgage, there are two numbers that determine the rules of the ARM. For example, you may see a 7/1 ARM. The first number, 7, means how long the mortgage payment is fixed. For a 7/1 ARM, the payment is fixed for seven years at the stated fixed interest rate, based on a 30-year fixed payment. The second number, 1, refers to how often the interest rate adjusts, so in this case, every one years. The rate adjustment is almost always based on the “Prime” interest rate. The prime interest rate is set by banks, based on the “Fed Funds Rate”, and the prime interest rate is usually the lowest rate offered to borrowers with good credit. When the interest rate adjusts in an ARM mortgage, it adjusts based on the prime rate, which could be the prime rate plus a fixed premium, or it could just be the prime rate itself with no added premium. All this depends on the terms of the mortgage, so it’s important to understand the terms of your mortgage! So a 7/1 ARM starts with a fixed payment for 7 years, based on a fixed 30-year mortgage; however, after seven years, the interest rate adjusts once per year based on the prime rate.
ARMs can come in many shapes and sizes, such as 10/1, 15/1, etc. The most dangerous ARMs are the ones that have an interest premium attached to the adjusted rate. For example, the adjusted rate could be loaded with a rate of prime plus 1.5%. This means the adjusted rate on a 7/1 ARM in the eighth year would be the prime rate + 1.5%. Today’s prime rate is around 3.5%, so that would make the adjusted interest 5%. If interest rates increase dramatically, it could inflate your costs. Many people believe the presence of ARMs used in predatory lending practices (called subprime rates) is one of the factors that led to the Great Recession in 2008.
Not every ARM is bad, and it could result in a lower mortgage rate some years, but as interest rates climb, it could result in higher mortgage payments. The obvious downside to an ARM is the unknown future costs. The biggest failure I see in obtaining an ARM is simply not understanding how they work, and seven years later, the payment changes (for better or worse) unexpectedly. There are planning considerations with an ARM, just like any other mortgage. Oftentimes an ARM gets a lower introductory interest rate vs. a 30-year fixed mortgage, so it can be used to purchase a house and then refinance within the next seven years, especially if you are purchasing a house during a time when interest rates seem to be dropping. If you know you’ll likely pay the entire mortgage early, then an ARM might be somewhat of a nonfactor. Often, a physician will purchase a primary residence with an ARM and move to a new house sooner than the ARM fixed rate expires. This usually results in selling the house anyway.
I know of some physician mortgage programs that require a certain amount of home equity after a period, such as 10% equity in 10 years. To creatively make sure this occurs, two mortgages are issued. The first one is a 30-year fixed mortgage for 90% of the home value, and the second is a 10-year fixed mortgage for 10% of the home value. This basically guarantees 10% equity in a home after 10 years, assuming there isn’t a dramatic decline in home values.
Regardless of the structure of your mortgage, your financial advisor (like me!) can run amortization schedules (payment schedules) to help you understand the impact of the mortgage selection. You should also consider the insurance costs and property tax implications to better understand the full impact of the home purchase on your budget.
All in all, a physician mortgage is available to physicians to purchase a personal residence. Some physician mortgages are even available for second-home purchases or vacation properties in addition to the personal residence, as it all depends on the bank or financial institution’s rules. The physician mortgage is not normally available for rental properties, as those purchases generally go through a commercial lending channel, and some banks even have streamlined avenues available for physicians for this kind of lending as well.
Which financial institutions have access to physician mortgages? The big national and international banks are not normally going to have these programs available, so if you call a national bank and ask for a physician mortgage, you’ll likely be handed off to a mortgage lender to apply for an FHA loan or a conventional loan. Local banks are normally the first place to start, and I know of a few national lenders that only issue and specialize in physician mortgages. I like to compare physician loans and match the program that fits best with the physician. Understanding how these mortgages work along with the culture and expected relationships of the banking service is an important first step to selecting a physician mortgage.