Debt: Why Most Fear It, and Why You Shouldn’t
Debt...It’s one of those words you might’ve been taught to fear growing up. Everyone seems to be either “debt-free”, or “drowning in debt”, and these terms lead us to believe that debt is completely negative, and to be avoided at all costs. In reality, the majority of debt we see around us is negative, and sometimes ruins lives, but if handled properly and used to make calculated investment decisions, debt proves itself to be a very useful tool. In this article we are going to cover the following:
1. What is debt?
2. What does good debt and bad debt mean?
3. Different debt instruments
4. Long term and short term debt
1. What is Debt?
Let’s take a look at what this idea of debt actually is. Let’s say I have a friend, and this friend needs $100 to buy a new bike. I offer to lend him $100 in cash right now (principal amount), in exchange for the repayment of $100 in the future, plus interest. At its core, this is the idea of debt. Money that is borrowed now, and promised to be paid back at a later date, along with any associated interest payments. Interest payments are usually expressed in percentages, and paid back at whatever time the loan agreement states. Typically, if interest is paid monthly, the monthly payment would be calculated by taking the principal amount and multiplying it with the specified monthly interest rate.
The example used above was a simple one, however, if you were to walk into the bank and ask for a loan, you’d hear many other terms throw around, but the same underlying principle remains the same. To make sure you have a strong understanding of debt and how loans are constructed, let’s discuss some of those terms. Interest payments have been spoken about already, that is just the premium you pay on top of the original amount borrowed for the service of borrowing money from a lender (expressed as a percentage of the amount borrowed). The principal amount is simply the amount you borrowed today. In our bike example above, the principal amount was one hundred dollars. When you have taken on debt, and it has been secured by some of your assets, the debt is called “secured debt”. Essentially this means if you fail to repay your debt, your specified assets will be handed over to the lender, a common thing to see with mortgages (a loan is taken out to buy a house). These are only a few of the important terms, but they help build a better understanding of what debt exactly is.
2. What Does Good Debt and Bad Debt Mean?
In the first paragraph of this article, we mentioned how debt has a negative connotation at times, and this refers to what many describe as “bad debt”. Debt is used to make large sum purchases with borrowed money by promising to pay back that borrowed sum later on with interest payments included. These repayments usually happen in increments over time and depend on the size of the purchase. Now, this is what makes debt so appealing, yet so dangerous, the idea that you can buy something today, without needing to have the full amount in cash up front. Credit card debt and car loans from banks are two popular contributors to the never-ending cycle of debt. Don’t be mistaken. If used wisely, these forms of debt can be very beneficial, but if they are abused, you could end up being chased by debt for the rest of your life.
Now, let’s talk about how debt can be used to better a company/individual. A bond is a form of debt that a company issues in order to raise funds. Similar to my friend who wanted the bike earlier, Apple may want to construct a new factory, but does not have the funds currently to make it happen. Let’s say for example, that the CFO of Apple, Luca Maestri, decides that this factory is a huge opportunity and not beginning to build it is a huge mistake. In this case, in order to raise funds, Apple may decide to issue debt (bonds) to the public. A bond is essentially a promise by the company to pay back the principal at some specified date in the future (maturity date), along with fixed periodic interest payments, called coupon payments.
Instead of bonds, Apple may decide to raise funds using a different debt instrument (e.g. a bank loan), however, the underlying message is the same. If capital budgeting is done properly by a company, or even by a person, debt can be used intelligently to make great investments right now, increasing your profitability in the future. When you take on debt, you hope that your return on that borrowed amount is good enough to both repay the loan, and make you a profit. This is the idea of “good debt” and how you can use it to expand your wealth.
3. Different Debt Instruments
Debt can come in many forms. Now that you understand the basic concept of what debt it is, lets dive deeper into the various different debt instruments used in the financial world today. The following debt instruments are used by both large companies and ordinary people alike. In this section we are going to focus on debentures, bonds, mortgages, treasury bills, and finally, loans.
In contrast to a mortgage, a debenture is not backed by anything. This means it is unsecuritized debt, with no assets being put up by the borrower as collateral. For those that don't know what collateral is, basically it is an asset that is owned by the borrower, and if the borrower was to default (failure to pay back) on their debt, the lender would seize the asset that was used as collateral. In the case of a debenture, there is no collateral. This tends to make debentures a little risker, because it relies heavily on the credit history of the borrower. Debentures are issued by an entity in exchange for money, and this is where the debt is created, the issuer must pay back this sum at some point in the future. You won't see individual people or even banks issue debentures as frequently as large corporations and the government. Debenture holders will usually require a higher return on their investment than bondholders because of the increased risk level. Similarly to bonds, debentures pay fixed coupon interest payments as well.
A bond is a debt instrument that entities use to raise funds. When an entity issues bonds, people buy them. Once this exchange is made, in the bond agreement is specified some coupon rate, maturity date, and payment frequency. The coupon rate is expressed as a percentage and is the amount that the bondholder will receive every payment period. The rates are always expressed in annual terms, therefore the coupon payment on a $1000 bond with a 10% rate paid annually will pay the bond holder $100 every year. Whereas if the bond were to pay semi-annually, the bondholder would earn $50 twice a year. The maturity date is the date that the coupon payments end, and the bondholder will be paid back their original investment. In contrast to debentures above, bonds are a securitized form of debt, and are backed by collateral.
Have you ever wanted to buy a house, but just didn't have enough money? So have millions of other people, and that is why mortgages exist. A mortgage is a type of loan provided by a financial institution that helps people become homeowners through lending money. A mortgage is a debt instrument that is secured by an asset, or collateral, and in this specific case, the asset is the home you are attempting to purchase. If you take on a mortgage, and buy the house you have your eyes on, if you default on that mortgage, the house gets passed onto the bank, and they will then become the owners of the house. With mortgages, you ask to borrow some specified amount at an interest rate provided by the bank. Typically the better your credit score, the lower your rate will be, and this is helpful because your mortgage payments that repay the loan you took from the bank are a blend of interest and principal payments. The interest amounts are determined by the rate the bank provided you, and the principal payment is some fixed amount that is a fraction of the original amount borrowed.
Treasury bills (commonly referred to as T-bills) are a type of debt obligation issued by the US government. Treasury bills are backed by the Treasury Department of the United States and usually have a one year payback period (One year til the maturity date). Typically, treasury bills are regarded as extremely safe investments, thus yielding lower interest rates. These lower interest rates mean that a person who bought a treasury bill will have a smaller return on their investment because the investment in these bills is considered to be very low risk.
4. Long Term and Short Term Debt
The difference between short term and long term debt has a simple answer, that is, short term debt has a maturity of 1 year or less, and long term is any maturity more than a year. The way entities use short term and long term debt is a little more complex, so in this section we are going to dig a little deeper into how these two are used.
The issuance of any type of debt by a business is primarily for the purpose of raising funds. When debt is issued, the borrower is obligated to pay some sort of interest payment to the lender and this is where long term debt has an advantage for businesses. Long term debt is considered to be more risky, and the reason for this is because it takes longer for the lender to receive their initial investment at the maturity date. When debt is more risky, lenders require a higher interest rate because of the higher risk, and this is termed the required rate of return. The required rate of return is what investors require to be paid (expressed as a percentage, the interest rate), and the higher the risk of the investment, the more investors want to be paid, meaning the higher the interest rate. So why is this higher interest rate an advantage for companies you may ask? Well interest expense on a company's income statement can be written off for tax purposes and reduce the amount of tax a company pays, and this is the primary advantage of issuing long term debt. Essentially, you can get the same funding as if you were to issue short term debt, but you get to write up a larger sum of interest expense and pay less tax. This may seem nominal, but when a large corporation issues hundreds of millions of dollars of debt, this interest expense can be quite high and save the company a large sum of money. Usually, long term debt is termed financing debt, and this is debt that is used by an entity to finance new projects.
Short term debt is any debt that is repaid within 1 year. This type of debt is typically associated with operating functions of the business. What this means is that short term debt is not typically used to raise funds in order to finance projects like long term debt. Short term debt is better used for things associated with day to day running of a business. A typical short term debt item you will find on a company's balance sheet is its accounts payable. This amount on the balance sheet highlights how much money a company owes within the next 12 months for the goods or services they have purchased on credit. This credit payment essentially means the companys received some good or service and will be paying for it at a later date.
Debt requires two parties, the borrower and the lender. The lender lends the borrower money, and the borrower promises to repay that debt, plus all interest that was specified in their agreement, by some specified date. There are many more intricate instruments of debt out there, and this article has helped to shine a light on some of those overarching concepts. Hopefully now you have a much better understanding on how entities use debt in their day to day operations. Debt is a simple concept, but a tricky thing to use if you aren’t wise with your decisions. Finance is full of estimates and risks, but making sure those estimates and risks are calculated will give you the best chance at financial success.