If you started practicing dentistry sometime in the last decade, you know that being in debt is a fact of life no dentist can avoid.
An education at a private dental school can cost well over $400,000, and purchasing a practice in some states on either coast can set you back anywhere from $500,000 to $1 million. In the past 15 years, the average graduating dentist's loan debt has risen to $240,000,1 yet this number hides the fact that a small (but increasingly growing) number of dentists who specialize will have a student-debt level that can be more than two times that amount, putting tremendous pressure on new graduates and limiting their career choices.
In addition to student and practice debt, most dentists will also have a mortgage and will also be responsible for their children's higher-education expenses. Carrying a large amount of debt into retirement can be a huge problem for those who do not have adequate retirement savings.
For one thing, student debt is impossible to discharge in bankruptcy.2 Debt repayment should be a key component of every dentist's financial plan, and there is excellent and extensive advice on debt management offered by financial gurus like Douglas Carlsen.3 Let's concentrate on the basics of loan repayment and developing simple rules that will allow you to make an informed decision regarding your financial future.
Prepay or invest?
Whether you have student loans, practice loans or a mortgage, one of the most common questions is whether it makes sense to pay off your loans early or invest your money in stocks, instead. Do your loan interest rate and principal amount matter when deciding whether to repay your loan quickly? What rate of return do you need from your investment to justify investing, rather than prepaying the loan?
Let's take a 25-year, $500,000 student loan with 6.8 percent interest and a monthly payment of $3,470 ($41,640 per year), and consider two possible prepayment scenarios.
With 6.8 percent interest, if you opt for a 25-year repayment period you will effectively pay double your loan amount in principal and interest payments. On the other hand, if you pay off this loan in 5 years, you will save $445,000 in interest payments. (See Table 1.)
Let's now consider what happens if, instead of prepaying the loan, we invest the money. For each prepayment scenario above, we'll compare the remaining principal under the regular payments and the compounded extra payments at the end of the repayment period. The compounded monthly extra payments have to be larger than the remaining principal to justify investing instead of prepaying. The following table (Table 2) shows what happens when extra payments are invested over the repayment period at different rates of return.
Thus, the break-even point is achieved when our investment return is equal to the loan interest rate.
Based on the above example, we can come up with the following basic rule: to justify investment rather than prepayment with taxes included, the ROI has to be higher than the loan interest rate. Your ROI on loan prepayment will be the same as the loan interest rate, less any tax deduction.
There is one exception to this rule. Repaying smaller loan amounts, regardless of the interest, may be more satisfying than paying down a part of a large loan. Limiting the number of loans you have via consolidating or quick repayment of low-balance loans can be a good strategy.
This rule can also help us decide whether debt is "good" or "bad." If you are borrowing money to invest in a practice, this debt can potentially generate a return that would be significantly higher than the interest rate on the debt, so practice debt is "good" debt. Investing in a new luxury car, a boat or a vacation house may be a nice thing to do, but this is not the type of debt that would produce a return to justify this investment. Borrowing to invest in a depreciating asset is usually "bad" debt. While some might think of a home as an investment, the long-term return on a primary residence is mediocre at best, so I would also call mortgage a "bad" debt.4
Another important factor to consider is the overall cost of the loan. While prepaying a $200,000, 30-year, 4.5-percent mortgage will provide the same rate of return as prepaying a $1 million, 30-year, 4.5-percent mortgage, the difference in cost savings when refinancing each mortgage is staggering (Table 3). Prepayment savings (especially for high mortgage amounts) is the biggest reason to refinance your 30-year mortgage into a 15-year one, and to repay all large non-practice loans as quickly as possible.
Types of debt
While credit-card debt can be a problem for some people, depending on where you live a practice loan is probably the biggest debt you'll have, followed by your mortgage and student loans.
Investing in stocks vs. prepaying
- Practice loans. The interest for practice loans is tax deductible, and these loans are usually paid out over the period of 10 years. A typical loan has an interest rate of around 5.5 percent, so the effective interest rate for someone in the 33-percent federal and 5-percent state tax bracket is 5.5 percent x (1 - 0.38), or 3.4 percent. You can continue taking out practice loans if this will help your practice make more money.
- Student loans. In the case of the student loan in Table 1, prepaying the loan would effectively produce a 6.8-percent return on investment, given that for most dentists the interest is not tax deductible. While a typical graduate student loan will have an interest rate ranging from 6.8 percent to 7.9 percent, the good news is that a growing number of banks are letting dentists consolidate their student loans into a fixed-rate loan with an interest as low as 5 percent. This loan should be paid out as quickly as possible.
- Mortgage. For most dentists, the interest on their mortgage will be tax deductible. If you are in the 33-percent federal and 5-percent state tax bracket and your 30-year mortgage interest rate is 4.5 percent, your effective interest rate would be 4.5 percent x (1 – 0.38), or 2.8 percent. If your AGI is too high and your itemized deductions (including the mortgage interest deduction) are phased out, you might want to consider refinancing into a 15-year loan. If you happen to live in a state where an average house costs $1 million, refinancing into a 15-year loan may also be a good idea.
Why not just invest in the stock market instead of prepaying a 6.8-percent student loan? After all, historical return on the Standard & Poor's (S&P) 500 was 10 percent over the past 100 years.
Can we expect to get a 10-percent return if we invest in the stock market? From 2000 to 2010, the S&P 500 10-year return was 0.4 percent, and from 2003 to 2013, the 10-year return was 9 percent. However, from 2000 to 2013 the return was only 3.5 percent. A conservative balanced/diversified portfolio may have gotten about a 6.5-percent return over that time, yet a portfolio with 50 percent in stocks and 50 percent in bonds still fell as much as 25 percent in 2008, and no one knew how long the markets would remain down.5 In 2010, when the S&P return was 0.4 percent annualized over 10 years, a CD or a money-market fund seemed like a great investment choice. Most consequential stock market returns (both positive and negative) happen in short periods of time, and one or two good years can easily skew the annualized return numbers. A decade of bad returns can be transformed by a quick rally, or a decade of good returns can be destroyed by an even quicker crash.
Extrapolating a historical return into the future can create a false sense of security and may lead us to assume (unrealistically) that all we have to do is wait long enough to get a 10-percent return from the market.
Market statistics (and research) do not support the hypothesis that historic average returns can be expected in the future. There may be scenarios under which a portfolio can get a return higher than 10 percent, but it can also experience negative returns and long periods of drawdowns, so it is not advisable to count on the stock market to outperform your loan. Because loan repayment provides a guaranteed return, it is always better to repay a high-interest loan than to invest.
If you refinance your student loan, you might get a rate that is closer to 5 percent. Should you invest in the stock market rather than prepay this loan? I would still argue that if you can prepay your student loans, you should do so, provided you take the following steps first:
If a retirement plan is not available to you, invest after tax until you can buy your own practice. If you are paid as an independent contractor, you may be eligible to open your own "solo" 401(k) plan.6 As a practice owner, you can start with a basic retirement plan, such as SIMPLE IRA or a Safe Harbor 401(k). After you pay out your student loans, you can always catch up on retirement savings by using a custom-designed 401(k) plan and/or a Cash Balance plan.7
- Establish an emergency fund that will cover between six months and 1 year of your expenses.
- Contribute to Roth IRA. Use a ‘backdoor' contribution via a non-deductible Traditional IRA if you are phased out.
- If you are an associate, contribute to a retirement plan, at least enough to get the employer's matching contribution.
Whether you prefer to repay your debt quickly or take your time and invest your money instead, simple rules can help you develop an optimal approach to managing your debt. For any type of loan, if you want to invest rather than prepay the loan, your ROI (after taxes) has to be greater than the interest rate on your loan. It would be a good idea to prepay your loans carrying highest interest (such as student loans) as quickly as possible, because such prepayment generates a return that equals the interest rate on your loan (less tax deduction, if any).
Even if you can get an investment to generate a higher ROI than your mortgage interest, it is still a good idea to repay your mortgage more quickly (ideally by refinancing into a 15-year mortgage), because the cost of your mortgage is proportional to the mortgage amount, so the higher the original mortgage, the larger your mortgage cost will be. While very few dentists are totally debt-free, the quicker you shed most of your "bad" and unessential debt, the sooner you will be able build up your savings. Whether you want to retire early or continue practicing dentistry, being financially independent will give you more control over your future plans.
Konstantin Litovsky is the founder of Litovsky Asset Management, a wealth-management firm that offers flat-fee, comprehensive financial planning and retirement plan advisory services to doctors and dentists. Litovsky specializes in setting up and managing retirement plans for small practices, including 401(k) and defined benefit/cash balance. He can be reached at email@example.com.