Efficient Debt Management and Physician Mortgages
September 20, 2017 | Marshall Weintraub, CFP® and Michael Merrill, CFP®, CLU®, ChFC®
Debt. Most physicians become familiar with it in one way or another throughout their careers; whether it takes the shape of student loans, credit card balances or a mortgage. Although Merriam-Webster defines debt as an amount of money that you owe to a person, bank, company, etc., we can also express the meaning of debt as borrowing money from your future self to access now, knowing you will have to pay back an amount greater than the principal borrowed. This article will review how to efficiently manage debts before using doctor mortgages as an example.
The Cost of Each Debt
Some sources of personal finance literature claim the best way to pay off multiple debts is by ranking them by the size of each balance and paying extra toward the debt with the smallest balance first, then the next smallest balance, and so forth. While it is natural to have some emotional satisfaction when a debt is completely paid off, this method will result in you paying more interest over the life of all loans and is less efficient than paying debts in order of interest rate from a total interest-minimization standpoint. Instead, we suggest you think of the interest rate on each debt balance as "the cost of the debt" the lender charges you for access to money now instead of later. For example, if you had a standing balance on your credit card that was accruing interest at an annual rate of 20%, we would consider this an expensive debt to hold on to. It is costing you $20 in interest every year you maintain $100 of credit card debt. On the other hand, an auto loan charging you a 2 percent rate is a very inexpensive debt, as it only costs you $2 a year for each $100 of the loan. Each dollar you pay toward your credit card saves you $0.20 in interest, while you only save $0.02 in auto loan interest. If you can stay disciplined with repaying your debts, then you will pay less in interest by focusing on the highest interest rate debt independent of the balance on each debt.
One application of physician mortgages is how you decide to finance your next home purchase. Physician loans allow you to make far less than the traditional 20 percent down payment (often a 0 percent to 10 percent down payment) and still avoid paying mortgage insurance. Why is this helpful? You may have debts that are at a higher interest rate than your mortgage (think "costing you more in interest each year"), so it would be a more efficient use of your money from an amount-of-interest-saved perspective to minimize your home down payment and instead apply your cash to higher interest rate debts. For example, let's stay your mortgage has an interest rate of 4.50 percent. That is not bad, but keep in mind the interest paid on the first $1 million of your mortgage is tax deductible. If you are in the 33 percent federal income tax bracket, then your effective, or after-tax, interest rate is only 3.00 percent.* If you have debts above 3 percent, then you will pay less in interest among all your debts if you make the minimum payments on your mortgage and pay extra on your higher rate debts. Physician loans allow you to avoid pre-paying on a low interest rate mortgage and instead apply the amount that would have gone toward the down payment to instead be applied to more expensive debts.
As you develop your debt management plan, we encourage you to focus on the interest rate of each debt instead of the size of the balance for which debts to prioritize. One caveat is if you are planning to have your student loans forgiven through the public service loan forgiveness program (PSLF). If this is the case, then it may make sense to pay the minimum on your forgivable student loan balances.
This article was authored by Marshall Weintraub, CFP® and Michael Merrill, CFP®, CLU®, ChFC®.
* 3.00% after-tax interest rate = 4.50% pre-tax rate × (1 – 33% marginal income tax rate)