Welcome back to the Financial Pulse! Last lesson we talked about how to read your pay stub. Today we are focusing on another behemoth of resident finances: debt. We will be chatting about interest rates, how to calculate interest costs, and the concept of debt consolidation.
So let’s talk about debt. Almost all residents have it, and most of us have a lot. At the end of medical school we have an average of 158,000 dollars of debt to our names. Even though debt is pretty much an essential part of training to be a physician, debt can be a cause of stress - how much is too much? How will I ever pay it off? How should I manage it during residency? Knowing more about your debt can help you feel more in control.
Consider the example the corporate world sets for us: companies take on debt to make more money later. For example, a widget maker might take on debt to open a new factory that makes the latest widget. They expect the new factory will lead to more profits, some of which they will use to pay off the debt they incurred to build the factory in the first place. Similarly, we take on debt to finance our training, so that we can make more money later on as staff. Debt can help make our lives easier during some of the most challenging years of our medical career. On the other hand, our access to debt can also present a temptation that can impact our financial future. Understanding our debt can help us be mindful of these decisions, so let’s dig in!
We can have many forms of debt - lines of credit, credit card debt, car loans, student loans, mortgages.... it goes on.
Let’s start by talking about what all debt has - an interest rate.
Interest rates generally tell you how much you’re charged for taking on debt. Interest rates come in two flavours.
Fixed interest rates are a specific, set rate. For instance, a credit card may have a 20% annual interest rate.
Variable interest rates are a bit more complicated. They are often expressed relative to the prime rate, such as prime - 0.25%. The prime rate, technically, is set by each bank. However, it’s usually the same between banks, and is based on the Bank of Canada’s overnight rate. You can do a whole degree in what causes the overnight, and therefore the prime rate, to change.
For now, know this: the prime rate will slowly be raised while an economy is doing well. It will be lowered during economic troubles. For example, the prime rate was 6% in early 2007, before falling to a low of 2.25% by 2009 due to the Great Recession. The prime rate has been historically low since, though gradually increased to 3.95% by the end of 2019.
Another thing to know is that, the prime rate is not necessarily the best you can get. Mortgages may carry interest rates that are below prime. Currently, medical student lines of credit are available from the major banks at prime - 0.25%. As the current prime rate is 2.45%, our current line of credit interest rate is 2.45 - 0.25 which equals 2.20%. This is a historically low rate.
Another important part of debt to understand is how interest is calculated.
Banks will describe interest rates as an annual rate, so that 2.2% is an annual rate. Your monthly statement will often quote the annual rate. Confusing? It gets better, because banks usually calculate your interest on a daily basis.
Calculating your daily interest rate is easy. Take the annual rate and divide it by 365.
So for example, suppose your line of credit has an annual interest rate of 2.20%. Divided by 365, the daily rate is 0.00603%. The banks multiples this number against your current principle – how much money you owe. The daily rate times the principle is the amount of money you are charged per day for the privilege of borrowing money. Although the interest is calculated daily, you generally only incur the interest charge once a month. So on your statement, there is a single monthly interest payment due.
Credit card debt is similar. There’s no debt on your bill until the payment due date. After this, it’s again calculated as a daily rate. This means that technically, you get a period of debt free borrowing every time you use your credit card, since interest does not start accumulating until the date your payment is due. This is great in theory, but you have to remember to always pay off your credit card on time!
You can save money by transferring debt to whatever charges the lowest interest rate; this is called debt consolidation. For example, credit card interest rates are usually much higher than the Line of Credit interest rate, so using your line of credit to pay off credit card bills usually makes sense. Most other debt vehicles will have interest rates that are higher than your line of credit’s interest rate. Mortgages are an exception, with their interest rate often being even less than a line of credit’s.
Student loans can be a bit tricky as the interest rates vary depending on whether they are federal or provincial student loans, and even then, the interest rates vary between the provinces. Another complicating factor is that student loan interest payments can be claimed as a tax credit at the lowest marginal rate, usually around 15% of your income, but interest payments to a line of credit cannot be claimed as a tax credit. Finally, it’s important to highlight that some student loan programs don’t charge interest until after residency, and other programs allow debt forgiveness. So there are circumstances where consolidating student debt into your line of credit does not make sense. Your personal circumstance may vary, and it all depends on the conditions attached to your student debt.
Let’s wrap up with one more calculation example that can also show a trick to save a bit of money:
Suppose my monthly credit card bill is 2000 dollars. My payment due date is 21 days after the statement date.
Let’s say I’m going to pay it off using my line of credit. For those 21 days, my credit card does not charge me interest. But, if I pay off the credit card right away instead of waiting till the due date, that 2000 dollars will sit on my line of credit for an extra 21 days. How much that does matter? Well, let’s take the daily line of credit interest rate, 0.00603%, and multiply that by 21 days, and the principal amount of 2000 dollars; wham; 2 dollars and 53 cents. So, I could save a bit by not rushing to pay off that credit card early. But; be careful to not be late with those payments; if I miss my credit card due date, I can incur that calamitous 18% interest charge. Even for just a day, that’s 0.049315%, which works out to 99 cents! Ignore the credit card for a whole week, and you’ve racked up 6 dollars and 90 cents in interest charges. That adds up quickly!
I hope you’ve learnt a lot today. We talked about what debt is, what the common types of debt are, what an interest rate is, then got deep into some math and even went through a quick example. We’ll catch you in our next lesson, which is all about Insurance.