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Do-it-Yourself Finance, Part III: Debt by Douglas Carlsen, DDS

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Psychotherapist Phil Tyson lists two factors involving the psychology of debt. First is a psychological principle he labels "future discounting." We often take on debt giving little thought to how we need to change our lives to accommodate it. Dr. Tyson's second principle is the relationship between consumption and personal identity. "Advertising has brainwashed us all to consume brands that provide us an identity. Our self-esteem becomes captive to products."1

Revolving Credit Card Debt

If you don't do anything else, please eliminate credit card debt. Not paying off completely each month is such an easy, yet insidious trap. Not only does it inhibit your ability to save, it psychologically entraps you. Many dentists carry well over $50,000 in revolving debt, often paying more than $10,000 annually in interest.

Remember Dr. Bill and Jennifer? They pay off their cards intermittently with an average unpaid balance of $3,000. Their main problem areas, as identified last month, are clothing, entertainment and vacations. They've struggled to avoid revolving debt fees, yet with the big cutbacks to the three above budget areas, they will be able to pay off their cards monthly by late 2013.

Autos

According to the Money-zine.com calculator (www.money-zine.com/Calculators/Auto-Loan- Calculators/Car-Depreciation-Calculator), a $40,000 auto will normally depreciate $9,200 in the first year, followed by $4,800, $3,800, $3,200 and $3,000 in subsequent years.

A rollover (continual) three-year lease for a $40,000 auto, which primarily covers depreciation, would average $5,933 per year forever, before dealer profit, assuming one leases a new car every three years. To buy a two-year old car for cash and keep for three years, one would spend $3,333 in depreciation per year, using these figures. That's a difference in payment of $2,600 per year before dealer profit, which is normally more than 10 percent. Adding 10 percent, the difference is $3,200 per year. For two autos, that's $6,400 more per year for the rollover leases.

Investing that $6,400 per year conservatively (4 percent real growth) for 35 years can generate $500,000 in today's dollars for retirement!

Dr. Bill has leased a 2012 Lexus RX 450 Hybrid SUV ($45,000) for $866 per month for 36 months, including down payment and lease. Jennifer has a leased 2010 Lexus IS 250 sedan ($32,000) for $637 per month for 36 months. Together, they pay $18,000 per year for cars they will never own. To purchase new at 4 percent interest and keep for 48 months, their loans would average $1,000 and $700 per month respectively, for a bit higher yearly total of $20,400. The bonus is that they'd have two autos worth $20,000 and $18,000 to trade in to significantly reduce the loan next time.

Consumer Reports consistently states that the worst way to buy a car is via a lease. Second worst is dealer financing. The best way to buy is cash.

Home Mortgage

Last month we covered home maintenance and improvement costs and how they can subvert one's finances. This month we look at the mortgage.

Charles Farrell, author of Your Money Ratios, points out that the maximum amount of mortgage debt should never be more than twice your net family income. By age 50 it should be down to 1.5 times income to retire by age 65. By age 65 it should be completely paid off.2

Farrell also makes it clear that your primary residence value increases only at the rate of inflation over many years.3

No, you won't be able to fund your retirement via your personal residence. The more mortgage you have, the less you'll have to save for retirement.

Dr. Bill recently refinanced his home for $740,000 at a jumbo rate of 4.5 percent and is paying $3,750 per month, $45,000 per year. Unfortunately, his mortgage is above two times his family income of $300,000.

What can he do? It's totally unrealistic to sell the home, so we attack upgrades. As indicated last month, if Dr. Bill can stage upgrades to 1 percent, or $7,000 per year, he may be able to save at a reasonable rate.

Student Loans

Student loans provide skills that increase a dentist's potential income level. Yet they often decrease that dentist's wealth-creating ability.

Dave Ramsey, author and TV personality, provides detail of doctor/student debt with a phone-in program recording that can be heard at: http://a1611.g.akamai.net/f/1611/23575/9h/dramsey.download.akamai.com/23575/audio/mp3/MyDRS%20Blog/
04022008__dont_get_docitis.mp3.

An abridged version:

Dear Dave,

I'm 33 and a resident with $250,000 in student loan debt. Next year I'll finish my residency and increase my income dramatically. The interest rate on my student loan is just 3.5 percent, so I'd like to postpone paying it off and make house payments and begin saving for retirement instead. I'd put off paying the student loans as long as possible. Is this a good idea?

- Derrick

Dear Derrick,

That loan hanging over your head is unbelievable. I've worked with many doctors over the years where 20 years later they are still playing math games with the student loans like they're stupid pets! If you're not careful, you might catch a nasty disease called "doc-itis." Some of the symptoms include two or three leased BMWs and a fully furnished house with a pool on the golf course. "That student loan can just wait a while to be paid." It's a financially debilitating disease.

You've been used to living on nothing (less than $40,000) for a while now. Just keep on doing that for a little bit longer. You can have that student loan debt knocked out in a few years.

I'd postpone any retirement savings and buying a home until you've completely knocked out the loan and have an emergency fund ($50,000+) in place...

- Dave

What can a young dentist do? Unfortunately, suck it up and live like a student for a few years after becoming a doctor. One who pays off student debt quickly will have real savings by age 50.

The insidious part of lingering student debt is that it inculcates a lifestyle of constant debt accumulation, never being totally debt-free. The media promotes debt incessantly to our insatiable urges. And we dentists buy in like lemmings! Unfortunately a $200,000 to $400,000 student loan burden is common for dental grads today.

Our dentist, Dr. Bill, paid off $150,000 in student loans within five years of dental school graduation and his wife, Jennifer, has student loan debt of $160 per month that she will pay off completely within the next year.

Practice Loans

In 2013, Dr. Bill would like to upgrade computers and flooring in his office, which would require a loan of $25,000.

Because a practice loan is obtained for something that increases in value, it's quite different than other debt we've explored. Indeed, it is appropriate to an extent.

Brian Hufford's Financial Balance Guide provides additional guidance. From a dentist's net income, Hufford indicates that one should designate 25 percent to personal living expenses; 25 percent to all loans, personal and business; 20 percent to savings; 25 percent to taxes; and 5 percent to large personal or practice purchases.4

In this case, Bill and Jennifer have $300,000 in total income. They pay $45,000 for a mortgage, $18,000 for cars and $2,000 for Jennifer's student loan per year. Their loan total is $65,000. Since 25 percent of $300,000 is $75,000, they have $10,000 to use for a practice loan per year, right? Not so quick.

As we saw two months ago, Dr. Bill and Jennifer have expenses of $128,000 per year, not counting their loans. That's 42 percent, way higher than Hufford's advisement of 25 percent. Jennifer has found possible savings of $30,000 in 2013 that would bring expenses down to $98,000, or 29 percent. That's good until one sees that savings in 2012 was only $2,000. The extra $30,000 in 2013 must go to savings. Obviously, any practice improvement loan must wait.

The first maxim I learned from my accountant was never to take out a loan for something that depreciates in value. That has stood me well over the years.

Next month, we tackle saving and investing.

References
  1. Phil Tyson, Ph.D., "Do You Understand the Psychology of Debt?" downloaded at www.mens-wellbeing.com/2010/02/do-you-understand-the-psychology-of-debt.html on April 28, 2011.
  2. Charles Farrell, J.D., LL.M.,Your Money Ratios: 8 Simple Tools for Financial Security. New York, NY: Avery, 2010, page 79.
  3. Ibid, page 85.
  4. Brian C. Hufford, CPA, CFP, "Maximize Your Wealth: Improving Upon the Reality of Your Finances," AGD Impact, February 2010.

Author's Bio
Dr. Douglas Carlsen has delivered independent financial education to dentists since retiring from his practice in 2004 at age 53. For Dentists' Financial Newsletter, visit www.golichcarlsen.com and find the "newsletter" button at the bottom of the home page.

Additional Carlsen Dentaltown articles are at: www.dentaltown.com. Search "Carlsen." Videos available at: www.youtube.com/user/DrDougCarlsen. Contact Dr. Carlsen at drcarlsen@gmail.com or 760-535-1621.
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