In our last post, we talked about basics of equity. This post is the kindergarten class of Debt.
B for Borrower
How many times have you borrowed money from your friends? (Of course with the intention of never returning it back) Many of the grown-ups and settled ones amongst us must have borrowed money from banks to fulfill the biggest wish of life of having a house. This borrowing behavior forms the first leg of term ‘Debt’. When we borrow money, we owe that money to whom we have borrowed that money from. We are obligated to pay that money back. We have plenty of reasons to borrow money! Just like humans, the companies (the not so loved child of human beings as discussed in previous post) also borrow money. Companies also need money for n number of things. They might need it for their day to day operations or for purchasing some costly machinery.
L for Lender
The kind-hearted person who gives you the money forms the other leg of term ‘Debt’. These kind-hearted people do not demand much from you. They just demand some interest on the money which they lend you. They also do not interfere in your activities. They simply want their interest regularly no matter what your condition is. In case of companies, this means that lender doesn’t care whether the company is making profit or not, they simply want their interest regularly and also want their principal back when the tenure of loan gets over. You see, the lenders are even crueller than the traders. The traders at least don’t have any direct involvement or pressure on the company. They simply make their profits by exploiting the fluctuations in share prices. But these lenders are so inhuman that they will even close the company down if they are unable to recover their loans! And that’s perfectly legal! When you save your money as fixed deposits or recurring deposits in bank, you lend the money to bank. In return, bank pays you interest and the principal when the tenure is over.
J for Jokes apart
Well, the above two paragraphs are in no way meant to undermine the importance of lenders or traders in the financial system. Everything is written on a lighter note with the intention of giving readers a moment to smile while they read our boring post :)
C for Credit Risk
When someone invests in a company as an equity holder (i.e. by purchasing shares), they take all the risks associated with the performance of that company. They take the oath of being with the company in all the sorrows and happiness :) So cute. On the other hand, do you think lenders have got any risk when they lend some money to another person or some company? Well, as the lenders do not care about performance of the company, they do not take risk as that taken by equity investors. But no matter how much pressure lenders may put on borrower to payback the interest, the borrower may completely go broke, unable to return any money! It can certainly happen. Or in some worst cases, a borrower might just run away taking all the money! Yes, that also happens and causes a lot of trouble for the lender. This is technically called as ‘Credit Risk’ or ‘Default Risk’. To reduce this risk, expert lenders like banks do a lot of checks on the borrower before lending the money. Often they measure ‘Credit’ score of the borrower before giving loans. The credit score is calculated by agencies like CIBIL considering your track record.
F for Fixed Income
So, you also have the option of making money by lending your money to your friends, banks or even companies! Should you? Or more apt way of putting it is, ‘when should you invest in Debt?’ Provided your borrower is good, lending money or investing in debt makes sense when you want a nearly fixed amount of income from your investment. In general, the interest rate and other terms of debt are fixed at the time of making the deal. Hence, if no default happens, then you get back a fixed amount, without any fluctuation like in share markets. The certainty of fixed income in case of debt does come at a price. You will generally get lesser rate of return in case of debt as compared to equity. In equity you take risk, but there are possibilities of making huge returns as well as of making huge losses. In case of debt, you have little chances of making loss and good chances of making a definite return. We haven’t considered the case of variable interest rates here, wherein you earn interest depending on the prevailing interest rates in the market. We’ll take that up in another post but the essence of that Debt is same as discussed in this article.
S for Short term Goals
Debt is very suitable when you are saving money for short term goals. Suppose you have to save some money to pay for down payment of a new car after 2 years, then saving through a recurring deposit would be a much better way as compared to investing in stock markets. Stock markets may go upside down in 2 years, but you will have no risk if you go with bank deposits. Hence, debt should be given its due consideration while making a financial plan. Debt has got its own importance. You might want to have a look at our article on Debt vs Equity to understand importance of debt and equity in different type of Goals.
P for Psychology
Debt is often the only mode of investment for people who are psychologically averse to risk. No matter what, some orthodox people will fail to appreciate the importance equity for long term goals, just because some 4th cousin of theirs lost money in stock markets attempting to make overnight fortunes through trading! If you have such people near you, refer them to our learning center :) That is why we exist :)
