By Dr. James M. Dahle, WCI Founder
Leti and Kenji at SemiRetiredMD ran a post a while back answering a question I often get: “Can I use a doctor loan to buy an investment property?” They correctly answered the question that, in general, you can't do that. Then, they pointed out a handful of ways that one possibly could do it and suggested some people from our recommended physician mortgage lender list that could help. I had some issues with the article, though. It wasn't that anything in the article was factually wrong. It was the fact that the article didn't address the elephant in the room, which is the question that should have been asked,
“Should I use a doctor loan to finance an investment property?”
The answer to that is almost always going to be no, but if you read that article, you would likely come away with the impression that the answer should usually be yes. Let me explain what I mean.
What Are Doctor Loans?
First, it's important to understand what a doctor or physician mortgage loan is. This is a mortgage loan you can get that allows you to buy a house with less than 20% down and NOT PAY Private Mortgage Insurance (PMI). Remember PMI is that insurance that you pay to protect your lender from you defaulting on your mortgage. It's a nice benefit to not have to pay it.
In addition, these loans will generally only consider your required student loan payment (rather than your true debt-to-income ratio) so, if you are in an Income-Driven Repayment (IDR) program, you can still usually get a mortgage even with a massive student loan burden.
Finally, a doctor mortgage can generally be underwritten based on a contract without requiring several months of actual paystubs. So, you can get the house before you start your job.
Why Would You Want to Use Doctor Loans?
Why would someone want to use these loans? Usually, it's because they are in a rush to buy a house. Frankly, by the time you are really in a position to buy that dream house of yours, you've got your student loans well under control, if not paid off completely (live like a resident); you know your job likes you and you like your job (and thus have 6-12 pay stubs); and you have a 20% down payment saved up. You can simply use a conventional mortgage and take advantage of its typically lower rates and fees.
But after deferring gratification for 10-15 years, many of us are in a bit of a rush and we often have a much better use for our money than a down payment, such as maxing out retirement accounts or paying off student loans. I'm not necessarily against doctor mortgages, but I think most people ought to at least consider saving up a real down payment and delaying that purchase, especially if you're looking at getting that dream house right out of residency (or worse, buying a house during a short residency).
An Unacceptable Level of Risk
So, if I'm OK with physician loans and I like real estate investments, what's the problem? The problem is that using a physician loan to buy an investment property generally brings an unacceptable level of financial risk into your life.
The math is pretty simple when it comes to buying investment properties. If the cash flow is positive, meaning the actual rent received is always more than the costs of the property, then you can own an infinite number of properties without ever running out of cash.
But if the cash flow is negative, then you are limited to a handful of investment properties, and that's if you are willing to dedicate a significant portion of your earned income to “feeding the beast” of those negative cash flow properties.
What is the best way to ensure your investment property will have positive cash flow? Put down 25-35% in cash. And if you're going to do that, you don't need a physician mortgage.
Remember that rent is not guaranteed. Consider the recent pandemic. One-third of rental payments nationwide were not made in April 2020. How many months of that can a highly-leveraged landlord take? Not very many. But a less-leveraged landlord with significant cash reserves can last a lot longer in a downturn without having to firesale properties (or start picking up extra shifts).
If you're only going to put down 0%-5% on an investment property, you better be getting such a sweet deal on the purchase that it will have positive cash flow anyway. That means you basically created 20%-30%+ of instant equity when you purchased and/or cheaply renovated it. That is a lot harder to do than most of the “Buy Houses with Nothing Down” books would lead you to believe.
Now, let's go through the various scenarios proposed in the article using physician loans to buy investment properties and point out some of the risks of doing so.
#1 Buy a Duplex and Live on One Side (While Renting Out the Other)
This isn't necessarily crazy, but it mixes business with pleasure. Lots of residents buy houses thinking they'll rent them out as a sweet rental property when they move out. But they don't go into the purchase thinking like a landlord. They go into it thinking like a homeowner. Homeowners care about colors, backyards, neighbors, commute length, etc. Landlords care about the cold, hard numbers:
- What will it rent for?
- What will the expenses be?
- What is the cap rate?
- What is the net operating income?
If you buy your duplex thinking like a homeowner, it likely won't be a great rental. If you buy it thinking like a landlord, it likely won't be a very satisfactory residence. Maybe you'll get lucky, but I wouldn't count on it.
#2 Buy a House, Live in It a While, Then Move Out and Rent It Out
Here's another scenario. You buy a house, live in it for a year or two (or, more likely, 3-5 years until you get out of residency) and then rent it out while buying another (perhaps with another doctor loan). A few lenders in some states will let you do this. But you still have the same problem. The mortgage is too high to allow the property to have positive cash flow. That rental isn't a blessing in your life and an asset on your balance sheet. It's a curse in your life and a liability on your balance sheet.
This is where you buy a home with a doctor loan and then rent out the bedrooms. Did I mention you're a doctor? Leti and Kenji suggest this as an option during medical school or residency, but I challenge them to find a lender that offers doctor loans to medical students. I don't know of one.
That leaves residency, maybe. Do you really want to work an 80-hour week and then come home to deal with issues with your tenants/roommates? If you think landlording is tough, trying living with the tenants. Especially if you have a partner. Or children. Or work long hours. Or are trying to sleep after a long call or overnight shift. Sounds like a good way to flunk out of residency to me, and that's assuming you can pack enough roommates in and charge them enough to provide positive cash flow. More likely, you'll find you're using a significant chunk of your limited residency salary to keep the whole thing going until you are rescued by your attending income. But you wouldn't know it from the article:
“The potential benefit of house hacking is obvious. Assuming you do it the right way, you could buy a property with no money down, live rent-free, and make an income.”
So, now you not only have to have positive cash flow, but you have to have so much positive cash flow that it covers your share of the expenses and provides additional income? Good luck. Remember you can't rent out the room you are living in! You better be going over your numbers with a fine-toothed comb (and have the rental contracts all lined up) if you think this is going to work out for you. It won't most of the time, especially after subtracting out the value of your time.
Yet another strategy . . . instead of going into the landlording business while in residency, go into the hotel business. I'm sure your attending won't mind if you take a call in the middle of rounds to line up this weekend's guests. Being an Airbnb Host seemed so smart back in January 2020. It didn't seem so smart in April 2020. Like with most things in investing, the potential rewards are higher because the risks and the amount of work required are higher.
Risks to This Strategy
To be fair, the article eventually acknowledged these risks to this strategy, but it continued to downplay them:
“There aren’t many downsides to using a doctor loan to house hack . . . One potential downside is that you may not cashflow as well with no money down because you’re borrowing a larger amount than you would normally . . . However, this can be balanced out by self-managing, which will lower your expenses significantly. You can lower costs even further by handling minor repairs and doing your own yard maintenance/snow removal.
It doesn't matter how many there are if they are big risks. Did I mention you're a doctor and your time at work is worth $100-$400/hour? That you went to medical school to doctor, not landlord?
“Also, any downside is far outweighed by the fact that you can start investing much earlier than you would have if you waited until after finishing your training. Not only do you start gaining valuable experience and real-life education, starting earlier means you benefit from the power of compounding to build your wealth even faster.”
As Ecclesiastes reminds us, there is a time and place for everything. Getting the cart before the horse is a serious risk here. I mean, if you really need to have a dozen rental properties by the time you're 35, why did you waste all that time in medical school and residency? You missed out on all that valuable experience and real-life education while you were learning the Krebs Cycle and battling EMRs. There will be plenty of time to be a successful real estate investor and reach FI by mid-career without having to use a doctor mortgage to buy your first investment property. Slow down!
“Another potential downside of putting less money down is that there may be a greater risk. By that, I mean, if there’s a downturn, you may have less equity in your property. So, if you need to sell it and move on, you might end up coming out of pocket to get rid of your property. This is especially applicable to single-family homes . . . However, you can completely mitigate this risk by buying the property the right way. This means that you do your analysis upfront, taking into account various issues that might come up and ensuring that your property continues to cashflow even if you run into some misfortune.”
Greater risk? You think? Yes, I agree that you should do your analyses up front . . . and make sure you take into account a global coronavirus pandemic. Oh, you didn't think of that? That's what risk is . . . the stuff you didn't, or even couldn't, think about.
Leverage introduces risk. Lots of leverage introduces significant risk. Infinite leverage (i.e. 0% down) introduces unmanageable risk. Don't take risks you don't need to take to reach your financial goals. In most cases, that includes using a doctor mortgage to finance an investment property.
What do you think? Would you use a doctor loan to buy an investment property? Why or why not? Comment below!
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