Practice Management Toolkit

Debt Management

The following is the second article in a two-part series.

Is Loan Consolidation Right for You? - Part II

Another concept not to be overlooked in any discussion of debt management and loan repayment is the time value of money. This topic is particularly poignant given that any consolidation of educational debt carries with it the implication that you are going through this process to lower your monthly loan payment. Reducing the interest rate is a key element, but extending the length of the loan is really what lowers the monthly payment.

If you recall the example in Part I (Figure 2), the payment on $100,000 in 10-year loans consolidated after the grace period dropped from $1,018 to $613 when the loans were combined into one, 20-year loan at 4.125%. Lengthening the payback to 20 years reduced the payment by $405 (the “savings”). Had those same loans been consolidated during the grace period, the rate would have dropped to 3.5% thereby lowering the payment an additional $33 to $580 per month. The rate reduction helped, but extending the loan to 20 years had a larger impact in a lowering monthly payment. A consolidated 30-year loan, with the added 0.25% rate reduction for agreeing to automatic monthly payments, has an even more dramatic effect. Here the loan payment falls to $435 from the original $1,018 for a total savings of $583 per month.

The “savings” are there, but you may be asking yourself if it is worth carrying such debt for three decades when it could be paid off in 10 years? And what about all that added interest you have to pay? With the 10-year repayment schedule the total finance charges amount to $22,208 on the $100,000 in loans. That sum jumps to $56,674 even with the lowest interest rate. Interest charges soars to a staggering $74,474 if the loans are consolidated after the grace period at the highest current interest rate. Is it worth paying that much more in finance charges for a lower rate and a lengthened repayment period? To address this question it helps to understand the concept of the time value of money and the potential for growth in investment accounts.

The Time Value of Money

With current stock market conditions being what they are, it is appropriate to ask “why should I invest?” Why not simply put any “savings” in a bank or credit union account where the money would be safe and insured? There are many obvious answers. For starters, that money may be safe but it certainly has no potential for growth (appreciation). But why do you need assets that can appreciate in value? Because in the years between graduating from dental school and retirement, you need to build a nest egg that can keep pace with, or hopefully exceed, the rate of inflation and tax increases.

It is generally accepted that the buying power of money decreases over time due to inflation and taxes. In other words, $1.00 today has far more buying power than it will 10, 20, 25, and 30 years from now. You have the option to repay loans in today’s dollars or extend repayment up to 30 years. By consolidating your loans, you will be making payments with cheaper, future dollars. In turn, you are retaining the more valuable dollars you generate right now for your benefit, not your lender’s. As a result, the money you “invest” has the potential to increase in value over time (appreciate) allowing you to treat time as an asset rather than a liability.

Lower monthly payments also permit you to deposit the money “saved” from loan consolidation directly into a retirement account at work, an individual retirement account, and/or taxable accounts. Such a strategy helps you on three counts. First, you start investing sooner rather than later. Second, you wind up paying off your loans with dollars that decrease in value over time. Third, you make maximum use of one of your biggest assets – time. If you postpone investing for retirement by 10 or more years simply to become debt free, you’ll give up years of potential tax-deferred or tax-free growth. You may be able to make more money later in life, but you can’t make up for lost time. Think of it this way. If your cash flow is limited and you choose to use most of your net income to pay your educational loans off in 10 years, you’ve just shortened by a decade the period over which you can invest for retirement.

The Growth Potential of Investment Accounts

After several consecutive years of a declining stock market, investing is definitely not viewed in the same light as it was during the bull market of the 1990s and early 2000. But as a young practitioner you may have a potential investing time horizon of 40 years. So it is certainly appropriate, and one may even say essential, that you look beyond today and tomorrow and think about your future. Individuals who fail to plan for the long-term and look only at today’s needs risk greater harm to their future financial well being. There are few guarantees in life other than the cliché of death and taxes.

Sound financial planning can and should include risk management, so even the most timid can find comfort in an investment strategy that focuses on attaining a solid financial future. Let’s now look at some examples where those potential monthly “savings” are put to work for you by being deposited in investment accounts. It would serve little purpose to overstate the potential for growth, so we’ll use very modest rates of return in the examples that follow. Use your own computer software program to vary the rates of return (both up and down) in anticipation of the direction you feel the markets will head in the future. But remember, your time horizon is long term and could span a period of up to 40 years. Not only do you need to save for retirement, you also need to learn how to manage your money while in retirement.

In the following examples, we’ll assume you opted to refinance $100,000 over 30 years at a rate of 3.5% (Figure 3). The estimated monthly payment reduction is $569. Let’s assume the first $3,000 ($250 per month) you “save” from loan consolidation is deposited in a retirement account. The remaining $319 per month or $3,828 per year can be deposited in personal (taxable) accounts. Your actual performance will vary, but in these examples the returns are set at the low rates of 3.0% and 5.0%. And for the purposes of this discussion, the same rates of return will be used both the retirement and personal accounts (Figure 3).

As the examples in Figure 3 illustrate, a “savings” of $569 per month or $6,828 per year has the potential to produce growth of $281,281. That is with a 3.0% investment return in an IRA and personal (taxable) accounts above the added interest charged to finance the loan over 30 years rather than the original 10-year period. That growth differential increases to $392,015 if the rate of return is 5.0% for the two accounts. Bear in mind that the personal accounts could generate taxable income and reduce the actual net growth. Furthermore, these examples do not factor in the negative effects of inflation and taxes.

Even with the 3.0% rate of return the reduced loan payment, resulting from loan consolidation, produced a net increase in assets. This outcome was achieved despite the added interest charges from lengthening the loan repayment period to 30 years. Do your own estimates by changing the rate of return to depict different potential outcomes, and see what results you obtain.

Retirement Is Not an End, It’s a Beginning

Many people think of retirement is an end point. But for all practical purposes, it’s better to regard this stage in your life merely as the point when you stop working and no longer have earned income. Your assets will have to provide both current income and growth (appreciate) to offset inflation and taxes, otherwise you may outlive your portfolio.

The Tradeoffs

As with anything in life, there are pros and cons to consolidating school debt. To provide a balanced picture of loan consolidation, two major tradeoffs should be discussed - increased finance charges and a protracted period of debt.

As mentioned in Part I, the total amount of interest paid on loans over two or three decades can double or triple. On the other hand, if you don’t spend the cash but take that monthly “savings” and invest it. Those dollars then have the potential to grow over those same 20, 25, or 30 years.

Equally as important, each year those consolidated loan payments are made with cheaper dollars. Yes, that’s right, cheaper dollars. From the concept of the “time value of money” we know that $1 today will not have the value and buying power in 5 years or 10 years let alone 20 or 30 years from now. Inflation and taxes gradually erode the dollar’s buying power. Why else do you increase your fees periodically or give your employees raises if for no other reason than to keep pace with inflation?

Think about what your lifestyle would be like if your salary remained unchanged for 30 years? Even after just a few years you would begin to see a reduction in your buying power or you’d wind up with less net cash each month. This occurs because while the cost of consumer goods, services, and taxes all increase, your salary remains unchanged. That’s not a favorable financial situation. So it is important for you to understand that today’s dollars hold more value than the dollars you’ll receive in the future. And this is the very reason you want to consider consolidating your loans, so you can reduce your monthly payments, extend the loan repayment period, and use the “savings” to invest for your future.

Another tradeoff is that debt repayment continues for decades. So you must be willing to manage this ever-present financial obligation. Quite honestly, not everyone is comfortable doing so. Some people detest the fact that school debt lingers on for what seems like an eternity, while others don’t mind it at all. But so it goes. Despite this ever-present debit on your personal balance sheet, you can minimize the financial pain by making the loan payment via an automatic monthly transfer from your bank checking or savings account to your lender.

Would You Be Better Off to Consolidate and Invest the “Savings”?

As you might imagine, there is no one response to this question. Attitudes about carrying debt and investing differ widely.

To some debt is a worrisome financial burden that must be paid off as quickly as possible. To others a substantial amount of student loan debt simply goes along with obtaining a professional education. There was no escaping it in other words, but it can be minimized through loan consolidation and a lengthy repayment period.

Managing the “savings” produced by loan consolidation can also be viewed negatively or positively. You have decisions to make as to how best to save or invest that money. Make bad financial decisions, and you could see any potential benefit go right down the drain. After all, the stock market wreaked havoc with the wealth of millions of investors when the technology bubble burst in 2000. If you have good results investing the “savings” during the 30-year period you may realize the full potential benefit illustrated in the examples. Make poor decisions and you risk wiping out the benefit of this strategy. So weigh your decisions carefully and avoid risky ventures.

Do Your Own Personal Financial Analysis

Given this introduction, it is now time to personalize the process so you can determine if loan consolidation is right for you. One of the best ways this can be accomplished is for you to analyze your own personal financial situation. Determine how much loan consolidation can save you each month if the repayment period is extended to 30 years. Remember, you can probably repay the debt early without penalty should you later wish to do so. But you can only consolidate loans once.

So use Figure 4 and run the numbers for your personal situation. Then decide if loan consolidation is right for you. Good Luck.

About the Author

W. Patrick Naylor, D.D.S., M.P.H., M.S. is an adjunct professor at the Loma Linda University School of Dentistry where he lectures on personal finance and investing. He is author of the book, 10 Steps to Financial Success, A Beginner’s Guide to Saving and Investing (John Wiley & Sons, Inc.). Dr. Naylor also wrote a dental text, Introduction to Metal Ceramic Technology (Quintessence Publishing Co.).

Together with Loma Linda University he created a self-paced personal finance CD-ROM entitled “Personal Finance Series for Health Professionals” based on 16 hours of lecture. The CD-ROM consists of four parts: Series #1 - Savings and Investment Basics, Series #2 - Investment Selection I – Mutual Funds, Series #3 - Investment Selection II – Stock Selection and Investment Tracking, and Series #4 - Investing in Tax-Deferred Accounts. The topics in all four of the series are of general interest, but Series #4 contains a section devoted to retirement plans for the dental office.

The personal finance CD-ROM can be purchased from the Loma Linda University School of Dentistry for $35.00 (including shipping in the continental U.S.) by calling (909) 558 - 4685 or sending a check for $35.00 to Continuing Education, Loma Linda University, School of Dentistry, Loma Linda, CA 92350. Loma Linda School of Dentistry also has several dental CD-ROM programs available for sale.

Dr. Naylor’s personal finance book can be obtained from any of the large, online book retailers, such as www.Amazon.com, or ordered by a local bookstore. His dental textbook is available through the Quintessence Publishing (800-621-0387 or 630-682-3223).