Case Study: How to Prioritize Debt

Recently, a dual physician couple, held a debt planning meeting with me. They had various financial obligations and one spouse had just received a rather large bonus. This couple is not US-born and are not totally rooted in our customs. In their country of origin, however, debt is a big no-no. For one spouse, it was a huge emotional burden. Spouse #2 had become more “Americanized” and simply wanted to follow our advice.

Another couple, physician spouse and successful business owner, also wanted our opinion on debt prioritization. They have a mortgage on rental property and their home, along with a sizable business loan. This couple does not have any emotional attachment to being debt-free – they just want to make good financial choices.

I thought this would make a great post on how to approach a debt payoff plan for other physicians who have multiple categories of debt. Our couples have the following categories of debt:

  • Student loans
  • Business loans
  • Car loan
  • Mortgage on primary home
  • Mortgage on rental property
  • Investment debt

Conventional wisdom is to pay off the debt using either a debt snowball or a debt avalanche. But we’re not talking about credit card balances here and that’s where those methods work best. Given the complexity of the debt most physicians have, I believe in taking a more nuanced approach and paying off debt starting with the least beneficial and working up to the most tax beneficial. Here is what I would advise someone with the above debt profile – pick and choose to fit your situation:

  1. Student loans or car loans – in this case, you are getting no tax benefit whatsoever. Look at these as a package and apply the debt snowball or avalanche. If you have 6-figure student loan debt (in which case, you should NOT have a car loan in the first place), pay off the car loan and move on to student loans. If the car loan has 0% interest, start with the student loans. You get the idea.
  2. Mortgage on primary home – because the standard deduction is now $24k for married couples and you can deduct only $10k of combined state income taxes and real estate taxes, you’re probably getting very little benefit from your mortgage interest. This goes next. The only exception I can think of is if you have a sizable home office in an expensive home. In that case, you will get to offset earned income with a proportionate amount of mortgage interest.
  3. Mortgage on rental property – Mortgage interest on rental property is 100% deductible. It may not be 100% deductible in the year you pay it, but you’ll get to carry unused amounts to the future, to offset future rental income or be used up when the property is sold.
  4. Business loan – Business loan interest is 100% deductible in the year you pay it. This is the most valuable category of interest and should typically be saved for last.

What about the investment interest deduction on the investment debt? This is a tricky one and one we try to avoid when a client is taking out a loan. Investment interest can be used only to offset investment income. Investment income for a physician will be taxed at 23.8% (20% dividends or LTCG tax and 3.8% Net Investment Income tax) while the top rate for “ordinary income” is 37%. That makes the investment interest deduction much less valuable than a mortgage on rental property.

Unused investment interest can be carried over indefinitely. For an accumulator, most investment income is going to be locked inside your retirement accounts and not available to offset your outside investment interest. I’ve seen clients build up mid six-figures of investment interest expense carryover and get to use only a few hundred or thousand of that each year because of the lack of investment income.

For that reason, I’ve left investment interest for the “it depends” category. If you can avoid it, do so. If you already have investment debt, analyze whether you will be able to offset future investment income in the next 5 years. If so, I would put it at #3 on the list. If not, it would rise to #2.

Naturally, if you have high-interest credit card debt, fast-track that to the top of the list. Work some extra shifts, destroy the debt and, if necessary, your credit cards.

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