Why does our very own U.S. government charge twice as high an interest rate on student loans than your neighborhood bank down the street? What’s the difference between an installment loan and revolving debt? In Diagnosing Debt, Michel Hatch, MD will address those questions and more.
I tend to think of debt as a necessary evil for most Americans, although for most purchases, it’s not necessarily, and it’s really not evil, either. An investor can be compensated for some risk by investing in debt instruments, and the debtor can have things and reach goals more quickly with the use of debt.
Dr. Hatch is an anesthesiologist and CSO (the S is for Strategy) at Doc2Doc Lending, a platform intended to lower the interest rates for personal loans specifically to physicians. We do have a referral relationship; if you work with them, this site may be compensated, contributing to our charitable mission. Take it away, Dr. Hatch!
Diagnosing Debt: Demystifying Interest Rates & Loan Terminology
Preamble: This is part 1 of a 3 part series on “Diagnosing Debt: a deep dive into the role of debt (beyond the world of student loans) in the financial life of a physician. The series will aim to shed light on optimal strategies for leveraging debt when necessary, and eliminating it when possible.
Part 1 explores basic knowledge around debt and risk, and aims to demystify the vocabulary used to describe it. Part 2 will take the form of three “case studies” demonstrating real-world scenarios often faced by physicians and exploring various avenues for navigating them. Part 3 will explore the idea of transitioning from borrower to lender/investor through early stage investment.
For the vast majority of physicians, debt – in some shape or form – is a fact of life. Student debt is a near-universal reality – and a long-known hurdle for medical professionals to overcome; the average student loan tally among physicians at the conclusion of medical school has reached $201,490. (it’s $292,159 for dentists2)
Beyond student debt, nearly all of us will use a mortgage to buy a first home, will utilize credit cards to facilitate consumer spending, and may take on other forms of debt to fund major purchases, join a practice, or pursue a “side-hustle.” While debt products are indeed ubiquitous in the lives of physicians, the nuance with which most of us understand the terms and circumstances surrounding these instruments is highly variable.
The aim of this post is to provide a basic foundation of knowledge surrounding debt and to demystify the terminology used to describe it so that we, as physicians who are often put in positions when we must consume debt, can better understand in which situations it can be more helpful or detrimental in helping us achieve our goals in our personal and professional lives.
Debt and Risk
At its core, an understanding of debt requires an understanding of the calculation of risk. The structure of all debt tries to take into account the need to provide a lender with a reasonable return on funds deployed, given the risk profile of the borrower and the intended use of the funds.
Elements of this calculation include the borrower’s financial history (as captured in a FICO score and credit report), the presence or absence of collateral (such as a house which can be foreclosed on by a mortgage lender, or a car which can be repossessed by an auto loan issuer in the event payments are not made), and the broader interest rate environment, e.g. how “expensive” is money in the existing economic context.
In our work at Doc2Doc Lending, we often hear exhausted 4th year medical students exclaim “I can’t believe I can buy a house with 0% down at a 3.5% interest rate, and the federal government is raking in 6.8% on my desire to get an education!” This frustration is real and understandable; and understanding of the types of debt (and how they relate to risk) will help to illuminate the logic here.
Types of Debt
Secured vs. Unsecured:
People borrow money for a litany of reasons, as enumerated above. A central distinction in the discussion around these loans is that of debt which is secured vs. unsecured. A secured loan is one in which the borrower has backed his/her promise to repay the loan with some tangible asset.
With a mortgage (the most common type of secured loan), the collateral is the house or – more precisely – the homeowner’s equity in the house. If a borrower stops paying his mortgage, the bank can foreclose on said borrower, take possession of the home, and sell it at market value – thus limiting its losses and recouping the original capital outlay.
Similarly, a car serves as the collateral in auto-financing. Medical practice loans typically require a lien on business assets and a personal guaranty from the practice owner. Collateral can be in the form of equipment, inventory, vehicles, and even accounts receivable.
All of these transactions represent secured loans – agreements in which the lender’s risk is limited by collateral and in which, typically, the interest rate (which reflects the riskiness of the agreement) will be lower.
The converse, unsecured loans, are backed by no such collateral. Student loans, credit card debt, and (most) personal loans are all examples of such loans.
In these arrangements, the only collateral a lender has is that of the borrower’s reputation (as represented by his/her credit score). If the borrower defaults on payments, there is no house on which to foreclose, no car to repossess, and no family heirloom to auction off to the highest bidder. As such, issuers of personal loans tend to charge higher interest rates and are more selective about the criteria one must meet to receive a loan.
At Doc2Doc, many of our borrowers ask how it is possible that student loans (which are technically unsecured loans), can be had at such bargain rates. Indeed, in the current environment of historically low interest rates, just about any borrower can borrow federal funds as a student at 4.53%.
Further, it is very common for graduating students to refinance their student loans with private companies at rates as low as 1.9 – 2.3%. Since we know that these loans technically fall into the unsecured category, how is that possible? There are three reasons:
- 1. Specific to federal loans, all borrowers are granted the same interest rate (currently 4.53%). This rate is determined primarily by current economic factors and not by a borrower’s credit history. For those borrowers with a less-than-stellar credit profile, this typically results in a substantial discount relative to the rates one would see for a personal loan.
- 2. Federal loans are funded by the federal government and have no statute of limitations. By contrast, other consumer debt like credit cards and personal loans typically have a statute of limitations of 3-10 years. The government offers a variety of graduated, extend, or income based repayment structures. Using these mechanisms, the Federal Government increases the likelihood that a borrower can and will repay. With a literal lifetime to make that happen (no statute of limitations), and unlimited collections powers such as garnishing tax refunds and social security payments, the likelihood of eventual repayment is much higher than would be expected with a personal loan of the same size to the same borrower.
- 3. For both federal and private student loans, the treatment of nonpayment is quite different than with a standard personal loan. Nonpayment of a typical unsecured debt ultimately triggers a collections process; eventually, continued nonpayment may result in a lawsuit in which a judge may grant a lender remedy through a garnishment of the borrower’s wages. If a borrower declares bankruptcy, the lender’s claim on repayment is rendered moot, ultimately resulting in a loss. Both federal and private student loans, however, are treated differently, as they are protected by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Therein, the requirements set forth for discharge of student loan debt through the bankruptcy process are incredibly rigorous. A borrower must prove undue hardship and must also demonstrate that he/she has made a good faith effort to repay. Basically, it’s very difficult to get around paying a student loan, even through bankruptcy.
Installment vs. Revolving:
Stated very simply, a revolving loan is one that has a credit limit that can be spent, repaid, and then spent again ad infinitum. Credit cards and a home equity line-of-credit (HELOC) are the most common examples – you can buy something using this credit, pay off the bill and then buy something else using the same line of credit.
An installment loan is one that the borrower repays in equal installments until the loan is paid off at the end of its term.
Both installment and revolving debt can be either secured or unsecured.
|Unsecured||Personal loan||Credit card|
Evaluating a Debt Agreement
If and when a loan becomes a necessary tool in the management of one’s personal finances, the vocabulary can quickly become confusing. If you’ve ever sat down to read the 3-page, 6pt Helvetica-font document that comes with any new mortgage or loan agreement, this will certainly ring true. Below, a quick refresher on the key points that need to be understood before signing.
This is, perhaps, the only truly intuitive term in the lot. The term is simply the period of time over which one agrees to repay in full the principal and interest on a loan.
Interest Rate vs. Annual Percentage Rate (APR):
Have you ever noticed that financial institutions never just give you an interest rate? Almost always, you will see an interest rate followed by a parenthetical (and typically slightly higher) number known as the annual percentage rate.
The APR refers to the annual rate of interest charged to borrowers, and is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan, inclusive of any fees or additional costs associated with the transaction. Said more simply, the APR might be thought of as the effective interest rate if one were to borrow money from a given lender and pay it back over the agreed upon term with on-time, every-time payments.
Since the APR is inclusive of fees, it is helpful to know what types of fees one might encounter in the selection of a loan. If you’ve ever signed a mortgage, you’ll be familiar with terms like origination fee, appraisal fee, recording fee, title insurance fee, and so on and so on.
In complex transactions such as the purchase of a home, these fees all serve to cover the costs associated with executing the transaction. Lending laws that have been improved since the 2008 financial crisis have brought greatly enhanced transparency to loans of all types (mortgages, car loans, student loans, and personal loans included).
For the most part, the fees associated with a transaction should be clearly spelled out and intuitive. One should also pay attention to fees paid in the form of penalties (returned check fee, late payment fee, prepayment penalty). Avoiding these penalties is typically a straightforward process which requires only abiding by the terms set forth in the loan agreement – but you first need to know what they are.
Finally, a word on amortization — the distribution of fixed-amount loan repayments into multiple installments, as determined by a repayment plan, or an amortization schedule. For simplicity’s sake, the payments one makes on a loan are typically divided into equal amounts for the duration of the loan.
Depending on the type of loan, the amount of each payment applied to principal versus the amount applied to interest can vary throughout the life of the loan. For the payments early in the amortization schedule for a home mortgage, for example, a greater portion of the payment is applied to interest, while more money is applied to principal later in the amortization schedule.
If you purchased a house with a 30 year mortgage at the start of a 3 year residency, only to move and sell your home upon finding your first “real” job, this may have been your first “aha” moment in appreciating amortization.
Below is a hypothetical example of the first 12 months of amortized payments on a personal loan with $50K borrowed at a rate of 7.99%. Note how the split between the payment attributed to principal vs. interest changes month to month.
Variable vs Fixed Interest Rate:
One additional term that may be somewhat self explanatory. When banks lend money, they often offer the option of choosing a fixed interest rate (which will not change throughout the life of the loan), or an interest rate that can “float” – that is, it can change at a specified time based upon a specified metric (most commonly the Prime Rate or LIBOR).
Variable rate loans typically offer an interest rate advantage up front (as the risk, to the bank, of rising interest rates is offset by the floating rate), but in a setting such as the one we are in today (with historically low costs of capital across the board), could prove less likely to result in savings in the long term.
Arriving at a Diagnosis
In medicine, one must diligently study through 4+ years of school and 3+ years of residency to learn the right questions to ask. Thereafter, one uses this approach to collect the relevant details of a patient’s presentation and ultimately, arrive at an informed and, more importantly, correct diagnosis.
As one addresses the role of debt in management of his/her personal finances, a similar construct is warranted. It is our hope that the above whirlwind tour surrounding risk estimation, loan types, loan structures, and the vocabulary to discuss it all leaves you poised at a financial graduation ceremony of sorts, green cloak donned.
In our next installment, we will use this newfound skillset to examine 3 doctors evaluating debt as a potential solution to personal or professional challenges and opportunities they face. Until next time!
Disclosure: Dr. Michael Hatch is the Chief Strategy Officer at Doc2Doc Lending – a novel lending platform created for doctors, by doctors, with the aim of facilitating fast access to personal loans at rates that make sense.
Doc2Doc was founded on the belief that doctors are a unique group that are more responsible in repaying debt obligations than the general population. Doc2Doc employs a proprietary underwriting algorithm which takes into account physician-specific metrics to enable interest rates which are often more favorable than those found at traditional banks. The above discussion should not be interpreted as financial advice. Dr. Hatch is neither a licensed financial nor investment advisor, accountant, or attorney. Any opinions expressed above are solely his own.
 Association of American Medical Colleges, 2019
2 American Dental Education Association, 2019
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What questions do you have about debt? What loans are you paying off right now?