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Keep Reducing Personal and Practice Debt
Chris VanStraten, CPA Partner, Baker Tilly
920 739 3400
> The role debt plays in your life
> Understanding true cost of debt and leverage
> Time Value of Money concepts
> Down payments and impact on rates
> Best uses of excess cash
> Tax advantages of debt
> Impact of debt on ownership and financial statements
> Considerations in evaluating debt financing structures
> Case studies
> Debt pay-off and saving guidelines
The Role Debt Plays
> Your goal should be wealth maximization during your lifetime.
> This means different things for different people.
> Debt can enable you to purchase something that increases your long term wealth (Practice, real estate, etc.) but requires a
capital outlay (Leverage)
> The key is to manage that debt, always staying on track with long term wealth creation.
> Understanding interest costs vs. capital appreciation.
Facts about debt
> Many graduating dental students have $200,000+ in student loan debt ($400,000 for private school students)
> Average loan to buy a practice is $450,000
> Personal debt includes mortgage, home loan, auto loans, etc.
> It can be daunting to face this much debt.
Debt Amount Cost Over Lifetime Value remaining
Student Loan (15 yrs at 5%) $200,000 $ 284,686 $ 0 Practice Loan (10 yrs at 5.5%) $450,000 $ 586,042 $ 450,000 Car Loan (5 yrs at 3%) $ 35,000 $ 37,734 $ 5,000 Mortgage (30 yrs at 4%) $350,000 $ 601,542 $ 350,000
Total $835,200 $1,607,487 $ 805,000
Facts about debt
Poll Question #1
Time Value of Money
A dollar today is worth more than a dollar tomorrow.
Save and invest early in life (investment doubles every 9 years on average)
> Analysis of interest costs
– 200,000 student loan over 15 years at 3.8%
– $1,459 monthly payment – $62,694 in interest paid
Instead, let’s say you try to pay down this debt to rid yourself of it and pay $2,500 per month
> Save $31,697 in interest
> Pay off in 7 years 8 months (nearly ½ of time!)
> Note trade off with investment returns (discussed later)
Time Value of Money
Leverage vs. Interest Rates
In general, leverage and interest rates have an inverse relationship
> The less down payment you have, the higher the interest rate
> This holds true for total debt to income ratio as well. Lenders will
become wary of lending you money if you have too much debt.
Determining best use of cash
If I have $5,000, should I invest this or pay down debt?
> Other option is to spend it (buy a car, clothes, etc)
In financial terms, you have to look at interest rates vs. expected rate of return.
> If you expect to get 5% return on an investment, and have a 4%
loan, you’re financially better off investing the money vs. paying down debt faster.
(assumes tax rates on income and deductions are the same)
Psychology of being debt free does not always match with this
Facts about debt
Poll Question #2
Tax Advantages of Debt
> Interest expense is tax deductible leading to savings on your tax bill.
– i.e. $20,000 interest expense could lead to $7,000 in tax savings (assumed 35%
– Note that principle payments on debt are not deductible, just the interest portion.
> You are allowed to depreciate the asset purchased, even if it is financed.
– i.e. you finance an equipment purchase of $100,000. You may be able to utilize this entire amount as a deduction even though you haven’t paid anything out of pocket yet.
– The immediate deduction is many times more valuable due to time value of money.
> Though financing is sometimes required, interest expense is still money out of your pocket, regardless of tax savings.
> End goal is wealth maximization, compare net cash out to income
Impact of Debt on Ownership
> Debt payments can consume large amounts of cash-flow
> Important to manage your lifestyle to enable debt payments to be made timely, and maybe even faster than scheduled.
> Large amounts of debt can make financing equipment purchases or emergency funding difficult.
> Your wealth is reduced by outstanding debt. A reduction in debt
increases your wealth.
Impact of Debt on a Financial Statement
> Income vs. Cash Flow.
> Cash vs. Wealth Creation.
> Liquidity risk and future purchases.
> Interest deduction / Principle reduction.
Profit & Loss
Fees Collected 733,750.19 Expenses:
Bank Charges 3,205.05
Bank Loan 56,755.00
Dental Supplies 48,109.01
Lab Fees 78,574.83
Meals & Entertainment 9,917.61
Total Expenses 731,123.69 Standard Model
Fees Charged (Memo) 737,457.00
Fees Collected 733,750.19
- Operating Expenses
(Personnel, Production, Facility, G&A) 161,516.98 Net Income Before Other 572,233.21
- Other Expenses:
(Equip., Financing, Associate, Fringes) 315,420.64 Net Income Before Doctor 256,812.57 - Doctor Compensation:
ADCPA Model Profit & Loss
Enhanced Management Format - Summary
Shopping for Debt
> When looking for financing in your personal or professional life, consider
> Long-term vs. short-term vs. cash flow (chart)
> Negotiate fees and prepayment penalties.
> If you can afford the extra payments, shorter term lower rate financing
maximizes wealth in the long run (assuming rate of return on investments is constant).
> Some lenders have financing specific to dental practices that may make
ownership financially feasible.
> Terms may be negotiable.
Long-Term vs. Short Term Debt & Cash Flow Considerations
$400,000 15 Yr. (6.5%) $400,000 10 Yr. (5.5%) $400,000 7 Yr. (4.5%)
Monthly Payments $ 3,484 $ 4,341 $ 5,560
Total Interest Expense $227,197 $120,926 $ 67,045
Total Cash Outlay $627,197 $520,926 $467,045
Paying Down Debt
If debt has you worried, it is important to have a plan to pay down your debt and stick to it.
> Start by paying off the debt with the lowest principle balance.
– Do this by making extra payments, to the extent you can afford to. Make the minimum payment on other debts.
> Once that debt is paid off, take the amount you were paying on that debt and apply all of it to your next lowest principle balance debt.
> Keep doing this until all debts are paid Avalanche Method
> Pick the highest interest rate debt to payoff first. Once done, apply
those payments to the next in line. Work your way down hill like an
avalanche to the lowest rate debt.
Case Study #1
Invest or pay-off early
Assume you buy a $450,000 practice with fully financed at 5.5% over 10 years resulting in a $4,884 monthly payment. Also assume you can invest and earn an average of 7% on your investments. If you have an extra $12,000 per year of income after expenses, should you pay down your loan or invest the excess? See table below for net worth comparisons after 5 years.
Extra Paid Towards Loan
Extra Paid Towards Investment
Year 10 Year 1
Practice 450,000 450,000 450,000
Investment - - 70,593
Practice Loan 450,000 187,628 255,675
Net Worth 0 262,372 264,918
Note: Interest rates on debt or investments have a direct correlation with risk. In this case, your investments must carry a higher risk to you then your mortgage does to your bank. Therefore, you can increase your net worth faster by investing any excess money
*tax rates on investments and mortgage interest expense assumed equal in both scenarios.
Case Study #2
Interest Costs on Debt
You are purchasing a new practice for $500,000, 100% financed through a bank. After qualifying for the loan, your banker tells you there are a few options available that are essentially the same except for the interest rate and term. The options are as follows:
1)7 Year Loan at 4.5% with a $6,950/month payment 2)10 Year Loan at 5% with a $5,303/month payment 3)15 Year Loan at 5.5% with a $4,085/month payment
At first glance, the 15 year loan looks appealing, however, it is important to consider total costs of the financing. Total interest costs on each loan are:
1) 7 Year Loan = $ 83,807 2)10 Year Loan = $136,394 3)15 Year Loan = $235,376
If the practice produces enough cash flow to service the 7 year debt at $6,950/month,
Case Study #3
Utilizing Debt to make an Investment
You’ve been approached by an equipment representative who wants you to buy a digital imaging system for $130,000. The claim is that the machine will allow you to do better dentistry including expanding your current offerings. In the end, he tells you that your production will go up by a conservative estimate of $35,000/year. The bank offers you a 5 year loan at 6% to purchase the equipment. After tax considerations, is it a good investment?
1)Assumes a marginal tax rate of 40%.
2)Equipment will be fully expensed in first year.
Case Study #3 (cont.)
Cash Flow Analysis
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Additional Income 35,000 35,000 35,000 35,000 35,000 35,000
Principle (22,992) (24,400) (25,905) (27,503) (29,200) -
Interest (7,165) (5,757) (4,252) (2,654) (958) -
Tax savings/(expense) 40,866 (11,697) (12,299) (12,938) (13,617) (14,000)
Cash Flow 45,709 (6,854) (7,456) (8,095) (8,775) 21,000
Net Present Value at 8% = $31,840