Brian Hufford, CPA, CFP
Managing debt properly is perhaps the most important challenge in overcoming financial stress and creating wealth throughout a career in dentistry. Managing debt incurred for student loans, practice purchases, and equipment acquisitions presents a major financial management puzzle to new dentists. For most young dentists, the solution to this puzzle is merely maintaining the lowest interest rates available and paying off the debt as quickly as possible. Is there any other way to manage debt?
Proper debt management cannot be viewed only in the abstract. It is not simply a matter of paying the least amount of interest and eliminating debt the most quickly. A dentist who eliminates all debt and has no savings has merely accomplished the feat of being broke again with no savings and no debt. This is where we were when we started college.
The bigger issue is how to eliminate the debt with the most safety, while maximizing wealth creation (i.e., the ability to comfortably retire). Eliminating debt the wrong way can sabotage wealth creation and peace of mind. The best way I know to think about this is a template I created, called "Doubling-by-Fives," which shows how a constant amount of savings grows each year. This template says that personal savings of $10,000 per year (e.g., in a 401(k) plan), will be worth approximately $60,000 in 5 years, $120,000 in 10 years, $240,000 in 15 years, $480,000 in 20 years, and $960,000 in 25 years.
The math doesn't work out exactly, and investment returns as well as savings are critical to the outcome-but it does illustrate the wealth-creation cost of waiting to save because of rapid debt reduction. A 35-year-old dentist who applies all cash flow to debt reduction for 10 years and then begins to save at age 45 would forfeit $960,000 minus $240,000 ($720,000) of wealth creation potential at age 60. It likely won't be quite this much with actual investment returns in today's environment, but the lost wealth creation will be significant. You understand the point. While a dentist will pay the lowest amount of interest expense by paying off debt rapidly, he or she will also forfeit a very large amount of compound growth potential that could have been realized by paying debt more slowly and having a plan to save 20% of income each year.
How about the risks of falling behind on debt payments? Consider two dentists who have the same amount of debt. One is locked into monthly payments of $8,000, and the other pays $4,000 on longer terms of repayment. One can see that risks are more associated with payment amounts than the absolute amount of debt. The other safety factor with debt is having a significant cash reserve. By structuring debt with longer terms and lower monthly payments, the debtor can create a cash flow margin that will allow significant savings for retirement as well as a significant cash reserve. While lower payments mean paying more loan interest, it can also mean more safety and the potential for significantly more retirement savings.
To guide dentists on debt management, we have created two rules of thumb. The first is tied to the critical goal of saving 20% of income throughout a dental career and maximizing wealth creation. It says that the overall amount of cash flow committed to debt repayment, both business and personal, should be no more than 25% of income. It is fairly simple to add the annual payments for all debt, principal and interest, and to determine the percentage of income committed to debt repayment. The second rule of thumb for debt management says that monthly payments should not exceed approximately 8% of the amount owed. If a dentist had $500,000 of debt, the monthly payments should not exceed 8% of that amount or about $4,000 per month. If, instead, payments are $7,000 per month, this dentist is throwing away $3,000 per month of wealth creation potential. It would be important to look at a complete restructure of all debt to avoid sabotaging wealth creation.
Over the years, we have heard 1,000 reasons why our views on debt management are wrong-that is, until the debtor realizes how quickly savings grow and accumulate by focusing on savings instead of rapid debt elimination. Why not ramp up your wealth creation potential?
Brian Hufford, CPA, CFP, is a wealth advisor and dental practice thought leader with Buckingham Advisors, a national, independent wealth and financial advisory firm with a specialty in helping dentists achieve their most important goals. To connect with Brian and Buckingham, visit BuckinghamAdvisor.com, call (866) 545-8816, or email [email protected].