This post will outline the basic structure of how to plan for long-term debt reduction and elimination and accumulation of wealth. This is a process that has a great deal of power over a long time range, so the sooner you start this, the more powerful the tools will be. It’s never too late to start, but a long time ramp gives a less steep climb.
Confronting reality
Getting a handle on your debt structure can be a daunting and stressful task. Confronting reality, however brutal that may be, is the first step. As an overall rule, there are three grades of debt, whether business or personal:
- Investment debt, where there is a tangible asset that was purchased with borrowed money. This can be something like a piece of equipment or clinic property on the business side, or a residence or an education on the personal side. Yes, the IRS considers Student loans personal debts. The amount of investment debt you can carry depends on your cash flow. Incidentally, student debt has now surpassed consumer debt as an overall total in the US.
- Speculative debt, where there is a tangible asset, but the borrower intends to sell the item at a higher price to someone else. Examples are stock speculation, house flipping, etc. I have even seen this with practice purchasing. This can closely resemble casino behavior and can be just as risky.
- Ponzi debt. This is borrowing to meet other debt obligations. There is no tangible asset, just increasing the debt load. The federal government has been doing this for quite some time now, and is represented by our national det. It’s currently more that $16 T. Don’t get me started!!!{{alert-links}}
The best way to get this outlined is to make a list of all debts of all types, separated by business and personal. If you have used a single credit card to pay for both business and personal, the best step is to estimate the division of the debt and pay it form the appropriate account. Separate credit cards help to keep things from getting mixed up in the future. You can use a handwritten list, or use a free calculator here.
Methods for debt reduction
There are several methods for debt retirement, but they all have one thing in common. You must have surplus income over and above what the minimum requirements are for your current debt service. Use of the calculator will tell you what the minimum amounts you must have available are, and lets you decide how much additional funds are going to be put to early debt retirement. There are a few main methods:
- Debt consolidation. This means taking debts currently costing a higher interest rate and placing them into a single vehicle at a lower interest rate. This is also called balance transfer. This does not lower the principal amount, but does decrease the interest payments over the life of the loan.
- “Avalanche” method: this means placing all excess payments against the highest interest balance first. Do this for any double digit debts or ones that you cannot consolidate into a lower single instrument.
- “Snowball” method: this means placing all excess payments against the lowest balance account first. The amounts you were paying against this balance, once paid of, are then applied to the second lowest balance. Use this method when interest rates are close to each other and on the low side.
Debt reduction or wealth accumulation?
From an accounting point of view, reducing debt or increasing assets are the same thing. However, from a cash flow perspective, they are not the same thing. The reason is that you need operating capital in both your home and business accounts to cushion against variations in income and collection rates. For a salaried employee, variation in income is zero, so this does not apply. But anyone who operates an independent practice knows that income and collection rates can vary substantially over short time ranges. Operating capital means that you do not have to borrow against future earnings to pay for current expenses.
How much cushion is necessary? For the business side, at least 30 days of fixed expenses is necessary, and 60 is preferable. Fixed expenses exclude pay or benefits to the doctors and any personnel who can provide billable services, such as massage therapists, athletic trainers, etc. For the personal side, an estimate of twice the normal “one-time” expenses should suffice. This may require some research into what you are actually spending money on, but it is a worthwhile exercise.
If you do not have any business operating capital, you should split your excess contributions by half into accelerated debt reduction and into retained balances in the business checking account. Once you have reached 60 days of fixed operating expenses, you can devote the rest of excess earnings to debt retirement.
Wealth accumulation has several aspects, which will be covered in the next post.
http://www.usdebtclock.org/