Typically the biggest purchase any of us will make in our lives is the home we’ll live in while we are in the heart of our careers. Too often though, I see people making some critical errors in their home purchasing and financing strategies that can damage their lifetime net worth.
How much you can afford and should afford are different
I have seen many folks make the mistake of thinking they can afford to purchase a property for the amount the bank approves them for. A physician must look at home purchases as a piece of your overall financial strategy.
When one compiles all of their financial goals (retirement, kids’ college education, potential vehicles and recreational toys, saving for a rainy day, etc.) they will find that the mortgage that fits into their overall strategy after Uncle Sam takes his cut is not as large as the bank may allude to.
We have found that, from a comprehensive financial preparation perspective, that most physicians can comfortably afford resident real estate purchases that total two to three times their gross income.
If the home of your dreams is more than this general guideline, it may still be reasonable to purchase as long as you accept the fact that you may have to work a few years into traditional retirement; may not be able to fund as much college for your children as you initially hoped; or may not be able to have all the extras in life that you hoped for.
On the flip side, if your property is financed for less than two times your gross wages, all the items mentioned above may come quicker than anticipated.
A historically low interest rate environment
A historical and long-term perspective on home financing is needed considering it is usually a long-term decision to settle into a sizeable residence. With depressed real estate in most areas combined with the fact that historically low interest rates are made available to us, it is a great time to be a buyer.
All physicians need to realize that locking into long-term fixed rates below 4% is an anomaly that all of us may never see again in our lifetimes. Freddie Mac rates topped off around 18.45% in October of 1981! More recently, 30-year fixed rates had been locked into in the early 2000s at above 8%!
We must not lose sight of the fact that we are all being presented with an opportunity to finance our homes (whether for the first time or re-financing … again). We must consider the advantages of this great opportunity for financing at interest levels close to that of inflation.
30-year fixed vs. 15-year fixed vs. Adjustable Rate Mortgages (ARM)
I am often asked what home financing option is the right one at educational lectures and among my client base. It is important to point out that financial advisors do not provide specific mortgage advice, and individuals should consult a mortgage professional for advice pertaining to their specific situation.
However, generally, the first determining factor is how long you think you will be in that home. If you anticipate that you will be in the house for a certain period (less than 15 years) it may be a reasonable option to consider obtaining a mortgage that is locked in for roughly two years beyond that time frame.
For a hypothetical example, if you know you will be moving to start your own practice in five years, then you may want to consider a 7/1 ARM. Note that with an ARM, it will generally result in lower monthly payments than a fixed mortgage during the term that is locked in; however, the loan holder accepts the risk of changing interest rates after that term. If rates move upward significantly after the term, your interest payments could increase significantly.
However, if there is a reasonable chance that you may not sell your residence for 15 years or more, one should consider locking into a longer term fixed solution. A huge variable that is often overlooked is that interest rates on a mortgage are deductible on your taxes. So you need to work off of the net cost of borrowing.
An easy hypothetical example is if you are in a 25% tax bracket and your fixed interest rate is at 4%. Your true net cost of borrowing against your net worth is 3%, because at the end of the year you are able to count all the interest you paid throughout the year when you itemize your deductions up to a mortgage of $1 million — even if you are, like many physicians, forced to pay under the Alternative Minimum Tax.
There is no question that you will pay far more interest on your home financing when stretching it over a 30-year vs. a 15-year fixed period, but this is a one-dimensional argument. If you are able to out-invest the net cost of your mortgage interest over the term of your loan, you could potentially create a larger overall net worth. You would simply have to put any money you would have put towards accelerating the mortgage into an investment that may outgrow the cost of borrowing over a long-term time.
When analyzing this decision, pay careful attention to your assumptions, which are not guaranteed. Investments will fluctuate and when redeemed may be worth more or less than originally invested.
Doctor mortgage programs
There are a handful of loan programs that are only available to physicians. These programs originated from the fact that most doctors can easily afford to pay their mortgages after medical school (and certainly when out of their residencies and fellowships), but traditional loan qualification programs would prohibit them from qualifying because of things like debt-to-income ratios.
There are a handful of national programs out there that are particularly advantageous, currently. The big factors that make these financing options so attractive is that they waive Private Mortgage Insurance (PMI) — which, for the record, is one of the largest wastes of money for a physician — and they allow you to retain the mortgage with sometimes as little as 0% to 5% down. The waiver of PMI and the opportunity to put little amounts down usually come with the stipulation that you have credit of roughly 720 or higher. I would suggest that whatever loan you are looking into waives PMI and offers the chance to put low amounts down at closing.
Jon C. Ylinen is a Financial Advisor with North Star Resource Group and offers securities and investment advisory services through CRI Securities, LLC. and Securian Financial Services, Inc., members FINRA/SIPC. CRI Securities, LLC. is affiliated with Securian Financial Services, Inc. and North Star Resource Group. North Star Resource group is not affiliated with Securian Financial Services, Inc. The answers provided are general in nature and are not intended to be specific recommendations. Please consult a financial professional for specific advice in relation to your individual circumstances. This should not be considered as tax or legal advice. Please consult a tax or legal professional for information regarding your specific situation. 520682/DOFU 6-2012