Managing Debt
In A Time Of Uncertainty
Edward C. Challberg, CPA
When you say the word “debt,” most dental students can share a story or two from their own lives. They may mention the student loans that they’ve taken out to pay for school, or a credit card that got out of hand during their freshman year.
The largest misconception with students is that they believe that once they join the workforce, they’ll be able to pay back those loans and live a debt-free life. It doesn’t occur to them, until much later, that there are high costs involved with opening a private practice. Facilities, equipment, payroll – all these take significant capital to get started, and for most of us, that means taking out loans.
In the current economic climate, the thought of starting a practice with such a loan can be downright frightening. After all, when times are good, patients want your services and promptly pay their bills.
There is plenty of cash coming in and you hardly think about debt, much less worry about it. But in times of economic uncertainty, patients may defer treatment or find that they simply don’t have the money for anything but emergencies. Patients may stretch out their payments making it harder for you to collect. Patients may lose their jobs and have to move out of the area to find work or a less expensive community in which to live. Your patient base may shrink.
So how do you, as a business owner, respond in a time of serious recession?
Step #1 – Get organized
Gather all your loan origination papers together and organize them in a notebook with a tabbed section for each loan and credit card.
Next, summarize your debt (loan, line of credit, and credit card) on a piece of paper, or you can use an electronic spreadsheet such as MS Excel. List your personal and business debts down the left side. Across the top, list the following about each debt item: Purpose of Loan, Loan Amount, Repayment Start Date, Interest Rate, Monthly Payment, Term, Total Payments, and Loan Limit if it applies. When that is complete, you’ll have a one-page summary of all your debt, which I suggest that you place at the front of your notebook.
The loan and credit information is now organized for budgeting, planning, and applying for consolidation or refinancing.
Step #2 – Project practice and personal cash flow
Cash flow has two components: 1) Cash receipts, cash coming in and 2) Cash disbursements, cash going out. Cash flow is the life-blood of your practice. Without it you won’t be in practice very long. In your practice, fee collections are the major source of cash coming in. Cash going out pays your practice expenses such as: rent, payroll, supplies, and lab bills. Outgoing cash can also fund your retirement, purchase assets, and service your debt. If you don’t have enough money to pay your lenders, it won’t be long before they are calling and making demands.
Together with your dental CPA, prepare a cash flow analysis of your last twelve months or last four quarters. Next, prepare a cash flow projection of the next two years by quarter. Include expected production and collections, scheduled pay increases, asset acquisitions, retirement plan contributions, and payments to service your outstanding debt. If revenues were to decline by 10%, what would you need to do to meet your debt service obligations? What if revenues declined by 20%? How would falling revenues affect your marketing, scheduling, treatment presentation, fee schedule, procedure mix, financial arrangements, staffing, use of available office space, patient communications, staff communications, and personal finances? Write out the necessary action steps to minimize the effects.
Analyze your personal finances and update your personal budget so that it dovetails in with your business cash flow projection. Normally, the best approach is to start with the end in mind and work from your personal goals through your personal budget back into your business plan. However, if your practice performance is significantly impaired by the effects of a deep recession, you may not be able to take this approach. You may be forced to compromise.
Simply by being pro-active, projecting cash flow, and creating business and personal action plans, you are more likely to respond positively to the negative effects of a recession and may even negate its effects altogether.
Step #3 – Implement effective debt strategies
The following strategies will help you to utilize debt effectively and efficiently:
- Minimize borrowing
- Keep your credit score high to obtain lower interest rates
- Prioritize your debt repayment in the order of the most costly debt first
- Consolidate or refinance to gain a stronger position
- Restructure your debt to make it more efficient
Minimize borrowing – You can decrease the amount of your outstanding loans by minimizing your borrowing in the first place. Borrow only as much as you need. Be frugal and stretch your available funds for personal living expenses by making wise choices. Be very judicious with credit card debt. Use it as a last resort rather than as an everyday convenience. If you want convenience, use a debit card that withdraws the funds immediately from your bank account. Use available cash rather than financing for items such as cars or boats. If that’s not possible, then consider a vehicle that is less expensive or previously owned.
Keep your credit score high to obtain lower interest rates – A credit score is a number usually between 300 and 850, based on a statistical evaluation of one’s indebtedness, which represents one’s creditworthiness. Creditworthiness reflects the likelihood that a person will pay amounts they owe in a responsible and timely manner. Banks, credit card companies, and other lenders use credit scores to assess potential risk of loss, which are reflected in the interest rates they charge. The three major companies that generate credit reports and scores are Equifax (www.equifax.com), Transunion (www.transunion.com), and Experian (www.experian.com). These companies use an evaluation technique based on the well-known model created by Fair Isaac Corporation called a FICO score. During recessions and difficult economic conditions, lenders are much more selective about the people to whom they lend and the terms. Credit scores are an important element in this selection process.
Credit reports often have errors in them. Check your reports every 6-12 months to eliminate errors and detect identity theft. Unauthorized accounts or address changes may be signs of identity theft. Call the creditor immediately, close the account, and follow other procedures recommended by the credit scoring companies. You are entitled by law to one free credit report every twelve months from each of the three companies indicated above.
Monitor changes in your credit score so that you can detect any unusual or unexpected declines. If there is a dramatic difference in one of your three credit scores investigate. A 50-point difference suggests errors or identity theft. Your credit score is available for a modest fee.
To keep your credit scores high, do not allow your credit card balances to rise above 35% of your authorized credit card limit. High balances lower your score.
Make your payments timely. Late payments drag your score down. Consider arranging automatic payments from a checking account. Automatic payments relieve you of the embarrassment of forgetting to make a payment because of distractions. Of course, you have to ensure that there is always an appropriate level of funds in the account so that a payment can be made without creating an overdraft.
There is a commonly held belief that having zero balances is desired goal. Keep in mind that for credit scoring purposes, some history is better than no history. Generate some modest activity in your accounts on a regular basis to optimize your creditworthiness.
Your credit score has a significant impact on the interest rates that you are offered. To illustrate the effect, consider a home mortgage. In my area near San Francisco, an average home costs $800,000-$1,000,000. A 90% mortgage is $720,000. Recently, a low FICO score of 600 resulted in an interest rate of 8.295%; a high FICO score of 730 resulted in an interest rate of 6.296%. The difference in the total interest paid over the life of the 30-year loan for these two interest rates is $351,720. $351,720 is the cost of a low credit score for this set of circumstances.
Prioritize your debt repayment in the order of the most costly debt first. Remember that the interest rate reflects the cost of borrowing. If you have extra funds to repay debt, you will minimize your costs by reducing the loan or credit card balances with the highest after-tax rates. Sometimes people are so anxiety ridden by their debt that they want to attack the highest balances first, or try to eliminate small balances so that they have one less loan to pay. Making emotional decisions lead to costly mistakes.
Consolidate or refinance to gain a stronger position
Should you consolidate your loans? The benefits of consolidating include:
Lower your monthly payments
- Streamline your expenses
- Eliminate higher interest rate loans
- Possible alternatives include:
- Refinance business debt
- Refinance the home mortgage
- Use cash from a home equity loan to pay off other debt
- Using a line of credit to pay off other debt
- Refinance an auto loan
- Using low or no interest credit cards to pay off higher interest debt
Consolidation decisions are fraught with traps for the unwary. Consideration must be given to tax effects, personal vs. business use, teaser rates, hidden charges, credit rating requirements, income restrictions, as well as bait and switch tactics. Always review your consolidation plan with a dental CPA who can analyze your situation with a critical, experienced eye and advise you as to the best course-of-action.
Restructure your debt to make it more efficient
Compare interest rates on an after-tax basis. Interest associated with practice debt is deductible. Interest on personal credit card debt is not deductible. Interest on a loan to purchase a vehicle used in the practice is partially deductible. Interest on loans used to acquire investments or education have specific restrictions. Assuming a tax rate of 30%, debt with deductible interest and a rate of 7% is equivalent to debt with non-deductible interest and a rate of 4.90% (7% x (1-.30)). Therefore, non-deductible debt with an interest rate of 6% should be paid down first if possible. A dental CPA can help you with these decisions.
Step #4 - Integrate your debt strategies into your business and personal financial plans and follow through
A good business plan includes elements of marketing, scheduling, treatment planning, receivables and collections, administration, education, personnel policies, accounting, and regulatory compliance. Personal financial plans include elements of tax, estate, insurance, education, retirement, and investment planning. Good business and personal financial plans will interface debt strategies with all these other elements.
Many people with spiraling debt and falling revenues are confronting the inconvenient truth that staying on the current course can lead to disaster. In some, the challenge creates paralyzing anxiety. Others go into denial and hope the debt goes away by itself. Neither approach is constructive. The correct path is to simply engage the planning process and get pro-active. Debt is simply a tool to use in building one’s practice and one’s life, a tool deserving respect and regular maintenance.
In summary, get organized, project your business and personal cash flow, implement effective debt strategies, and follow through with thoughtful business and personal financial plans. In addition, as the need arises, engage the services of other professionals like a dental CPA. If you do these things, you are more likely to respond appropriately to the vagaries of uncertain economic times and attain your financial goals. ■
Edward C. Challberg, CPA is a San Francisco Bay Area firm that specializes in dentists and improving their income and quality of life. Ed presents business and financial seminars at the School of Dentistry, University of California. For more details, visit www.challberg.com