Is Interest Working for You or Against You?

In 2006, dentist Dr. Gregory Gosch and his wife Susan unexpectedly received an inheritance, while there was still debt owed on their dental office and home.  Deciding what to prioritize—either investing or paying off debt, especially in this era of rising interest rates, is a common question for many dentists. 

Compound Interest, Friend or Foe?

"Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it." 

--Albert Einstein

Interest can be a key for dentists to generate long-term wealth. It can also be a hindrance to wealth generation since many dentists commonly have large amounts of debt early in their careers (school, practice, house, building, car, etc.).

Compound interest generates wealth when your money makes more money for you, and then that money makes you more money. Due to the compounding effect, the growth of your investments, retirement accounts, and savings is accelerated over time, making time your friend! The longer that your money has to grow and compound on itself, the less of your own new money you will need to save to reach your financial goals since more money will be generated from compounding.  However, considering how compound interest can work against you when you borrow money can also be a challenge, especially for new dentists starting with home, practice, and student loan debts.

Dentists who understand this “8th wonder of the world” may use compounding interest as motivation to pay off debts as soon as possible and start investing and saving to achieve financial freedom.

Back in 2006, Dr. Gosch was in a quandary where best to apply the funds of a large inheritance they received. He writes of how he and his wife handled their situation: 

“There was still debt owing on my dental office and our home. The market was doing well, so we were in a bit of a quandary as to where would be the best place to apply the funds. We turned to you as our trusted financial advisor to guide us.

You wanted to know the level of debt owing on the dental office and the home. The decision was to apply the funds to pay off the mortgage owing on the dental office, thereby freeing up cash flow I could use in the dental practice. This proved providential, because after the market downturn in 2008, I was able to maintain the cash flow at the office even though our monthly production decreased. Thank you, Nathan!”

 --Dr. Gregory Gosch (WA Dentist & former client, uncompensated)

Critical to empowering dentists to use this “8th wonder of the world” to achieve financial freedom is establishing financial planning strategies that include managing cash flow, minimizing the impact of interest on debt as well as leveraging interest earned with investments, retirement accounts and savings.  

What are 5 Ways to Minimize the

Impact of Interest on Debt? 

When we take on debt, instead of using interest to grow our wealth, we pay interest. In addition to the stated interest rate, compound interest has the potential to decrease wealth and work against you. For example, in a mortgage, the payment of principal and interest may be level, but a portion goes toward paying the interest and a portion goes to paying down the principal. Generally, at the front end of the loan, most of the payment is applied to interest with just a small amount going toward the principal. The amount going to the principal gradually increases over time, but the banks want to make sure they get paid on the front end!

The higher the interest rate, the larger the payment. Also, if you have a loan that you are unable or slower to pay back, interest can accrue and be added to the principal of the loan. In this case, future interest is based on the higher principal balance (this is called negative amortization). This can happen on debts such as student loans, personal loans, mortgages, and especially in high-interest debt like credit cards, causing those balances to soar.

What does this mean for a dentist, especially in this time of increasing interest rates?

“Interest rates should not deter new dentists from buying dental practices. Long-term wealth will be tied to stock markets and building up your practice rather than current interest rates.”

Dr. Megan Jones (WA Dentist client, uncompensated)

While it is common for dentists to have large amounts of debt early in their careers, the impact of interest on debt can be minimized through the following strategies:

1. Fix the interest rate to eliminate the risk of rates continuing to rise. You can always refinance if rates fall.

2. Check to compare your APR and rate of compounding. Comparing the annual percentage rate (APR) is how you can compare what you will be charged in interest rather than the simple rate. “Ideally you want your savings products to compound as frequently as possible and your debts to compound as infrequently as they can.” (“The Life-Changing Magic of Compound Interest” Forbes.com)

3. Shorten loan terms. This will directly save money on interest, but payments may be higher. However, often the increased principal payment and lower interest can offset the higher overall payments, so examining the amortization schedule to analyze this option is often helpful.

4. Manage cash flow to allow for increased payments. By making extra principal payments you will also directly save on interest. This is a good option to consider if you do not want to restructure the loan.

5. Decide to pay cash whenever possible. For example, try to buy cars with cash and don't carry credit card balances.

With interest rates as high as they are, dentists early in their careers are especially feeling the impact of larger payments, while dentists later in their careers enjoy the high savings rates and the decades of compound interest on their investments. Overall, the sooner that dentists can start earning interest instead of paying it, the better for their long-term wealth.