First of all, the term ‘getting out of debt’ is a misnomer. Sure, most consumer debt is bad, incurred at ridiculously high interest rates, and something you want to pay off as soon as possible, with a vengeance.
What we really want to do is increase your net worth. That means you want your assets column to increase faster than your liabilities column. That means not every debt you have is bad. Some of it can be very productive. For example, you incur debt when you take on a home mortgage. But that home mortgage also enables you to benefit from future home price increases that would otherwise benefit your landlord – who would raise your rent every year.
You probably took on debt to go to medical school. But that debt enables you to earn an excellent living with an expectation of income far beyond even your monthly debt service payment or the total amount of the loan.
Good Debt vs. Bad Debt
The first step is to know the difference between good debt and bad debt.
Good debt contributes to your bottom line, because it feeds the asset column an amount greater than the interest rate on the loan.
Examples of good debt:
- A home mortgage
- College education
- A mortgage on an investment property
- Debt incurred to buy equipment to start a business or private practice
In each of these cases, there is a tax deduction or a tax subsidy available. Interest on home mortgage debt is deductible up to $1 million. Interest on education debt is deductible to a certain extent. Federal student loans are also subsidized to an extent by the taxpayer. Interest on Debt incurred to buy an investment property is deductible in any amount, as is the purchase price (though you have to spread the deduction over 27.5 years for residential investment property via amortization). Interest on business debt is also deductible in any amount.
Each of these debts, if well-managed, constitutes an investment in your own future, and goes to fund future sources of wealth and security. Each of these makes your asset column more effective.
Bad debt, on the other hand, is a cancer on your bottom line, because interest and your monthly debt payments starve your asset column of cash that you need to make more productive investments.
Examples of bad debt:
- Credit card debt
- Debt at clothing/Department stores
- Personal auto debt
- Financing luxury goods
- Payday loans
Each of these debts generally charges relatively high interest, and does nothing to feed the asset column. They don’t protect your wealth and because of the interest rates, they do a lot to drain your cash flow of money you would be better off saving or investing.
Doctors, unfortunately, are vulnerable to the lure of bad debt. Too many doctors find themselves trying to keep up with the Jones’s, or trying to finance what they think of as a doctor’s lifestyle prematurely, before their incomes justify it.
If you’re a resident making $60,000 per year, you don’t need to be driving the same car as another physician who’s been in practice for 20 years, or buying brand new furniture to decorate your house like you think a doctor’s house should look, or taking the same cruises or ski trips.
Slow down, and be patient, and build a firm foundation.
How To Build A Firm Financial Foundation
The cornerstone of your foundation is insurance planning. The most important things you can be doing financially as you start your career in medicine are investing in your education, and protecting your investment with life insurance and disability insurance.
Do that first, or everything else you may consider is as vulnerable as a house of cards.
Next, get some cash in the bank. Create an emergency fund to tide you through any emergencies. Most experts recommend 3 to 6 months worth of monthly expenses. Don’t rely on credit cards for this. A financial crisis could eliminate your job and your access to credit at the same time. Have cash in the bank, or in a conservative cash value life insurance policy, if you have one.
Next, go through your debts. When it comes to debt reduction, eliminate the bad ones, high interest debts first (under the mathematical method) or from smallest to largest (under the ‘snowball’ method, which is probably more fun!).
When you get down to college debt and mortgage or investment debt, stop. Compare the interest rate you’re paying on the debt to whatever rate you can reliably and safely get from prudently investing the available cash. That is your hurdle rate. If your interest rate on debt is greater than your hurdle rate, keep paying down the debt. It’s the best investment you can make.
If the interest rate on your education debt or home mortgage is less than what you can get investing it, then make the investment.
Any new debt you incur has to be ‘good debt.’ That means it’s financing an asset – one that generates income, is expected to increase in value over time, or both.