When a person borrows something that eventually needs to be repaid, they are considered in debt. Financial debt can come in many different forms, such as mortgages, student loans, installment loans, lines of credit and credit cards. Both businesses and individuals can take on debt. When a business takes out a loan, it’s known as debt capital.
There are numerous reasons why debt might be taken on, however, the most common use is to purchase items that you can’t afford outright in cash, like a home or vehicle.
For example, most homebuyers don’t have the cash available to buy a home outright. In these instances, financial institutions will lend them money to close the deal, however, this isn’t free money. In fact, your total cost of debt includes numerous different factors, which we’ll explore later in more detail.
The lender you work with will dictate how debt is repaid. Common repayment methods include monthly installment payments and/or balloon payments.
There are two main types of debt financing: secured debt and unsecured debt. Knowing the type of debt you being held is important for making educated decisions.
Secured debt is when the borrower offers up an asset as collateral in exchange for a loan. The asset is used to or secure the loan in the event the borrower has to default. For example, if a business was purchasing a piece of machinery, the piece of machinery being purchased could be used as collateral to take out a loan against the purchase price.
If the borrower cannot repay the loan and ultimately must default, the lender would take possession of the asset. This reduces risk on the lender, which can ultimately translate into more favorable repayment terms and make the qualification process simpler.
Lenders that issue unsecured debt rely solely on creditworthiness and a promise to repay. This results in the borrower having a higher risk of default. To offset a portion of this risk, the lender might increase the cost of debt by raising the interest rate.
Credit cards, student loans, personal loans, and medical bills are all forms of unsecured debt. If a borrower were to default, the lender would need to pursue a court judgment, which can result in paycheck garnishments and the requirement to sell off personal assets, depending on the situation.
Contrary to popular belief, the true cost of debt isn’t the same as the initial loan amount. In fact, the cost of debt includes interest rates, fees, points, and origination fees. Let’s break down these items in more detail.
The first and most common expense worked into total debt is the interest rates. This percentage is usually based on a national market rate. For example, if 30-year mortgage rates are lingering around 7%, that’s what you can expect to pay on your loan.
Of course, borrowing history, credit scores, down payment, and geographic location can impact this number, but the market rate is generally the going average.
The type of debt taken on can also impact interest rates. Credit card interest rates can be well above 20%, while long-term loans usually stay under 10%. Be sure you know to take note of interest rates when applying a debt formula to calculate the total debt cost.
Two more factors that work into the total cost of your debt are fees and points. Sometimes, lenders allow borrowers to purchase “points” when taking out a loan. This is basically prepaying interest upfront and assigning a lower rate to the life of a loan.
Lenders will also charge fees for the work it takes to create a loan. Sometimes, these fees are minimal, while other times, they can be around 5% of the total loan cost. When looking for the true cost of your loan, factor in any fees and prepaid interest.
Lenders can adjust the terms of debt, including the rate of interest, the amount you qualify for, and the repayment terms. This makes it important to work with the right lender. Borrowers might find that the average cost of debt is much lower by working with one lender over another. Before you sign on the dotted line, compare all loan options.
Whether working toward paying down total debt or trying to lower debt costs on your next loan, it’s important to understand what can be done. Here are some ways borrowers can minimize the cost of debt:
Debt in the form of a loan is usually based on a credit score. A higher credit score indicates it’s likely repaying the loan will be reliable and on time. This helps the lender assume more risk. On the contrary, a low credit score skyrockets lender risk, which they will pass down to you in the form of higher rates and fees. Maintaining a good credit score can help a borrower secure more favorable loan terms.
There are hundreds of lenders fighting for your business. From first-time homebuyer credits to competitive interest rates, lenders have incentives in place to attract your business. Be sure you are taking full advantage of these incentives and shopping around for the best loan terms. Would it make sense to go with a lender that offers you a 7% rate or a 5.5% rate? Probably the latter.
Each month, when a borrower remits payment, the amount goes into two different buckets: principal and interest. This means if making a $1,000 payment, maybe only $700 is going toward paying down the loan (principal) and $300 is going towards interest. By making an extra payment, a borrower is paying down the principal, saving interest and putting themselves in a more favourable debt position.
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