Interest: Good, Bad and Ugly Side of Debt

For many dentists, loans are a necessary part of your career. Whether it is a student loan, car loan, home mortgage or a practice loan, at some point in your career you are likely to take out a loan, which means paying interest. Not all debt is the same, some are better than others. Managing your debt will help you become debt-free much faster and save you money.

AFTER-TAX COST OF INTEREST Many dentists are unaware of the after-tax cost of their purchases. This important concept will help you understand why some debt is cheaper than others. The concept of “after-tax” costs applies to every single purchase you make. It is the final amount including taxes you must pay in order to make a purchase. In order to pay $100 of interest to the bank, you may have to earn as much as $215 (100/1-.5353) if you are in the highest tax bracket. Of your $215 of income, $115 goes to taxes and the remaining $100 goes to the bank as interest.

The same concept applies to your interest rate. Even at prime of 2.70 per cent, the interest could have an after-tax cost as high as 5.81 per cent (2.70 per cent /(1-.5353)). This applies to all non-tax deductible interest on loans such as a home mortgage, student line of credit and personal line of credits. This is very different from tax deductible debt such as practice loans/line of credits, mortgages on rental property, investment loans and the business portion of automobile loans. When one incurs tax-deductible interest on loans, the total cost is equivalent to the actual interest rate being charged on the loan (i.e. 2.70 per cent if at prime). Consider the example below to see the total cost of paying interest for one year on a $100,000 loan at prime.

WHICH DEBT TO PAY OFF FIRST? Understanding the true costs of servicing debt will allow you to prioritize your debt repayment strategy and minimize your costs. For many dentists, consider paying off debts in the following order:

1. Credit card debt – Typically charges high interest rates at 20 per cent and above. We recommend paying this off in full each month even if you have to borrow to do so.
2. OSAP/Government student loans – Typically charges interest at prime + 2.5 per cent.
3. Personal line of credit/ Student line of credits – Usually at prime, but not tax-deductible.
4. Home mortgage – Usually at prime or below prime, but not tax-deductible in many cases.
5. Personal Investment loans – Usually at prime but tax deductible if used to invest and earn income. Repaid with personal after-tax dollars. If used for mixed purposes (some personal and some investment/business), interest will be partially tax deductible.
6. Practice loans – Usually at prime, tax deductible and repaid with cheap after-tax corporate dollars if held by a corporation.

For new graduates, although there is a tax break associated with OSAP/Government student loans, the tax breaks do not compensate you for the higher interest that is charged, which is typically prime + 2.5 per cent. We recommend you forego the tax breaks and take out a line of credit at prime to repay the OSAP/Government student loans.

TAX TRAPS CREATED BY BAD DEBTS If you have a professional corporation (PC), you may encounter a situation where there is no money to issue dividends to the shareholders and your PC has a deficit (i.e., total liabilities are greater than total assets). As a result, you may dip into the corporation’s line of credit in order to pay out dividends. This may convert good debt into bad debt. Under Ontario corporate law, there are restrictions on the ability to authorize dividends if your PC is in a deficit position. The CRA may take the stance that the interest paid on the borrowed funds to pay the dividends are not tax deductible resulting in additional taxes payable by the PC. Prior to issuing dividends, speak to your accountant to ensure you are onside to do so.

RECOGNIZE YOUR DEBT AND SAVE TAXESJust as good debt can turn into bad debt, you may also be able to turn bad debt into good debt by reorganizing your finances. Consider the following example:

Scenario:• Investments owned personally of $300,000• Mortgage on personal home of $300,000

Steps:1. Sell investments for $300,000; assume original cost of investments was $300,000. Therefore, no gain was triggered on the sale.

2. Use $300,000 in 1) above to pay off home mortgage.

3.  Borrow $300,000 and use loan proceeds to buy investments for $300,000.

Result:Convert non-tax deductible interest on home mortgage into tax deductible interest on investments.

Caveats:The investments purchased must be outside of a Tax-Free Savings Account or Registered Retirement Savings Plan. You should also review your mortgage to determine if there is a prepayment penalty. 

TAKING BACK CONTROL Historically low interest rates have made it cheaper than ever to borrow and acquire assets such as a home or a dental practice. If used correctly, debt and leverage can help you to acquire and grow your assets; however, debt can be a slippery slope. If you thought a 20 per cent interest rate on your personal credit card balance was a lot, consider how much it truly costs after you factor in the personal taxes you would have to pay just to repay the interest. Managing your finances and prioritizing debt repayment will allow you to control your debt instead of the other way around.