Properly Align Your Debt Payment Ratio
Debt can bring out some pretty visceral feelings. In fact, many dentists I speak with approach eliminating debt as the first priority of their financial plan. But the dental profession is a capital-intensive industry; from dental school through transition, you are likely to have some level of debt in your life. Thus, this ever-present piece of your financial situation can feel daunting.
In this article, I hope to show you that there is good debt, which can be used to accelerate your wealth creation, and there is a bad debt, which can be a destructive force to your financial well-being. I will also introduce you to a simple ratio you can use to determine the difference.
In essence, good debt is only good if the cash flow it produces is put to good use. Let’s take a more in-depth look at what makes good debt good and bad debt bad.
So, what, exactly, is good debt?
Yields income: Good debt can be used for income-producing activity. If debt is used to invest in an asset that, when debt payments are considered along with operating costs and capital expenditures, provides positive cash flow, then it’s good debt.
Leverage: Good debt will provide leverage, allowing your current savings to attain greater buying power. An example of leverage can be found in briefly modeling a practice purchase.
Using leverage properly allowed the dentist in our second scenario to realize five times the profitability in his purchase after accounting for expenses and debt service.
Rate: Good debt will carry a comparably better interest rate than bad debt. Good debt will have lower rates because it is collateralized by assets that have positive characteristics. We generally see good debt at interest rates higher than the risk-free rate (think government bonds) but lower than forward-looking return expectations on equities. This allows us to confidently employ the positive cash flow produced by good debt for long-term wealth creation by using it to invest in a diversified portfolio, as opposed to plowing it back into the debt itself.
In the following examples, we find ourselves with $350,000 of good debt at an interest rate of 5 percent. We’ll assume the borrower is in a marginal tax bracket of 40 percent (between state and federal). And we’ll also assume the borrower could achieve an annual forward-looking expected return of 7 percent in a properly diversified portfolio.
In our first example, we pay on a traditional principal and interest payment schedule with a five-year term. Once the debt is paid off, we then take a similar amount and save that for retirement. This provides approximately 20 years of savings starting in the sixth year of our 25-year example period. By the end of debt payments and our investment horizon, we have retired our debt and accumulated $5,676,292 in savings.
In our second example, we pay on an interest-only loan for 25 years, refinancing when needed. In this case, we are capitalizing on the lower interest rate of good debt. What we would have paid on principal, and the associated taxes to make the principal payment, we instead invest in a diversified portfolio, using our accumulated wealth to pay off the debt in its entirety after the 25th year.
By capitalizing on our lower interest rate and focusing on paying ourselves first, we are able to accumulate an additional $1.25 million over our lifetime.
In contrast bad debt has interest rates that far exceed the forward-looking return expectations for equities, often 10 percent to 20 percent or more. This debt carries no long-term wealth-creation opportunities.
Asset with expected output: Good debt does not always produce cash flow, but generally does have an expected output. A good example of this can be your primary residence. While you won’t get income from a primary residence, you generally anticipate this asset to appreciate. It should also provide growing equity, by way of the principal pay-down already in the mortgage payment and ongoing appreciation.
Be aware that good debt can become bad if you don’t put the excess income or output to good use. If you use the cash flow from good debt to aggressively pay down that debt, you may be missing out on one of the great advantages of a financial life planned early and well: time. And it’s focusing on the longer term that, again, allows you to pay yourself first.
To determine if debt payments are properly aligned with your wealth-creation priorities, we use the debt payment ratio. The debt payment ratio is: Total monthly debt payment / Total amount owed.
A debt payment ratio of less than 0.8 percent can be considered good. For example, if you borrowed $1 million, a monthly payment of less than $8,000 is good. If your debt payment ratio exceeds 0.8 percent, you should explore opportunities to refinance your debt to align it with the debt payment ratio that will allow you to maximize your wealth-creation prospects.
At the end of the day, debt will be a part of your life. Instead of lamenting that fact, focus on removing bad debt and using good debt for wealth-creation purposes, knowing the difference between the two, and checking regularly on your debt payment ratio.
If you have any questions about how to approach debt in your life and practice, the proper use of debt, or strategies for identifying and eliminating bad debt, please contact any of us Practice Integration Advisors at Buckingham Strategic Wealth.
This commentary originally appeared October 25 on DentalTown.com
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