Practicing medicine is one of the highest earning careers a person can chose. That success is often bundled with complex financial decisions. How to best allocate earnings often tops the list. As a physician, you probably started your career with more than $100,000 in student loan debt. Couple this with personal debt and the financial considerations of running your own practice and making decisions about what to do with extra cash in your practice can quickly become difficult. Financial decisions can be infinitely calculated and modeled, but some basic guiding principles can help set parameters to simplify the process.
Generally, those options can be boiled down into four decisions:
- Pay off any existing debt (business or personal)
- Invest the extra cash into retirement or other savings plans
- Reinvest into your business (buy newer equipment, hire more people, etc.)
- Increase your personal expenses (i.e. buy nicer things!)
In general, we would always recommend you maximize the extent of the first two options before moving onto numbers 3 or 4 (although number 3 may require some action depending on how your business is performing). For the purposes of this article, we will discuss how to decide when to act on numbers 1 and 2 and by how much.
When deciding to pay down debt vs. building for retirement, there are three main decision criteria to consider.
- Rates of return under each scenario
- Risk Tolerance
Many people automatically gravitate to considering risk tolerance first when it comes to debt. For example, many people simply don’t like having debt and want to pay off all debt as soon as possible before considering alternative uses for their cash. However, by overlooking rates of return people can potentially miss an opportunity to maximize their wealth creation.
Take for example a situation where you have the funds to pay cash for a car but the dealership is offering zero percent finance. You would be better off financially taking the loan from the dealership and investing the cash in an interest bearing account. If you made the debt payments from your savings account each month you would get to the end of the loan term and have some funds left in the account from the interest received over time. With today’s rates this might not seem like a sizable difference but the situation is magnified when you start considering larger dollars and increased interest rates.
So the simple decision with regards to criteria 1 is to invest into the highest rate you can. For example, if your debt incurs interest at five percent but your investments return six percent per annum, then the choice would be to put extra cash into your investments as over the long term you will generate more returns than you will pay in interest expense on your loan.
While the criteria number 1 decision is fairly easy to determine, it does not consider risk. Investments have a certain level of risk to them, typically the larger the returns the greater the risk that is being taken. Unlike loan interest rates that are typically fixed for a period of time. So in the above example, one could argue that while the investment returns are greater the risk is higher. The loan interest is essentially a risk free rate as it is fixed for the term of the note (if it is variable then it will have some element of risk to it). So when you add risk to the situation, the conservative approach would be to pay off debt first to account for the reduced level of risk being taken. The decision to go either way will depend on each individuals risk tolerance and the relative gap in rates between the options. It should also be noted that while investments have more risk to them this should be factored into the rates and that these rates are expected averages over a long term. Therefore, this decision process should consider the length of time the person will be investing. If it’s short term then the risk is much greater than someone investing over a much longer period who can ride the ups and downs that the investment might take. As a result you should apply less weight to the risk decision if the investment holding period was very long.
Criteria 3, taxes, will differ by individual and situation but assuming the extra cash can go into a tax deferred account it will almost certainly make sense to maximize payments into a tax deferred retirement plan before paying off debt. The reason being is that contributions into a retirement plan are tax deductible whereas payments on debt principal are not. Assuming a person pays tax at 35 percent that would be a 35 percent difference in benefit before considering the rate differences discussed above. While it is true that the tax deferred account will pay taxes when the money is eventually pulled out of the account the time value of money (i.e. $1 is worth more today than it will be in the future) still makes this an overly compelling decision, especially for those people who are a long way from retirement age.
In summary, when deciding how to best utilize any excess cash from your practice, first make sure you are maximizing your tax deferred investment accounts (assuming that they are returning suitable returns) and then if you prefer the rates you would get from investing in an essentially ‘risk free’ savings account vs. investing in other ‘risker’ investments (stocks, bonds, mutual funds, etc.), then pay off your debt next, otherwise consider investing those funds instead and making normal payments on your debt.