Debt comes in many forms like mortgages, student loans, credit cards and national debt. It can be advantageous or detrimental to personal, corporate or national finances. Some try to evade debt at all costs, while others see debt as an opportunity to grow their business or improve their finances.
Understanding different types of debt will help you reach your financial goals faster. We will explain long-term debt and examine why you may or may not want to use it.
Defining long-term debt (long-term liabilities)
Long-term debt, also referred to as long-term liabilities, is any debt that lasts longer than 12 months. It can be an excellent tool for businesses and individuals who need immediate funds for things like startup expenses, mortgage loans or another source of capital that can increase their financial leverage. At the same time, the banking industry and other lenders earn profits by issuing long-term loans that will accrue interest over time.
Creditors, analysts, investors and financial agencies use the long-term debt listed in a company’s financial statements to determine its solvency — the company’s ability to pay its debts. Companies must report their current and non-current debt in the liabilities section of their balance sheets. Current debt is debt that they must pay within the next 12 months, while non-current debt is long-term financial obligations.
Examples of long-term debt
Lenders issue long-term liabilities for different purposes and in different amounts. Some examples of long-term debt include:
- Municipal bonds: Municipal bonds are low-risk liabilities loaned out by a city, town or state to fund projects such as power plants, schools, highways and sewer systems.
- Corporate bonds: These types of bonds are issued to investors by a company to raise capital.
- U.S. Treasuries: U.S. Treasuries are debts issued by the U.S. government with terms of 2, 3, 5, 7, 10, 20 and 30 years.
- Bank loans: These are loans issued to individuals or companies by a bank or financial institution.
- Debentures: Debentures are business bonds or debts not secured by any assets.
- Mortgages: A mortgage is a loan backed by property such as a house or building.
- Leases: Leases are agreements detailing lease payments for land, property or services for a fixed period.
The current portion of long-term debt explained
On a company’s balance sheet, long-term debt is split into a second category called the current portion of long-term debt. The current portion of long-term debt is the segment of the long-term debt that the company must pay within the current year, which means it must have that amount in liquid assets.
For example, if a company has $50,000 in long-term debt and needs to pay $8,000 of that debt within the current year, the company would list $42,000 as the long-term debt and $8,000 as the current portion of long-term debt.
The current portion of long-term debt is one factor that helps investors and lenders determine how likely a company is to repay its short-term obligations. A large amount of the current portion of long-term debt and a limited amount of liquid assets will raise flags and questions as to whether the company can meet its debt obligations.
The long-term debt ratio formula
Analysts use long-term debt ratios to determine how much of a company’s assets were financed by debt and how much financial leverage it has. The long-term debt ratio gives stock market investors and lenders insight into how likely a company is to meet its debt obligations.
The formula for determining a company’s long-term debt ratio is its total long-term debt divided by its total assets. If a company has $700,000 of long-term liabilities and total assets that equal $3,500,000, the formula would be 700,000 / 3,500,000, which equals a long-term debt ratio of 0.2. The debt ratio of 0.2 means that 20% of the company’s total assets are unpaid long-term debts.
Lenders and investors usually perceive a lower long-term debt ratio to mean less solvency risk and that the company can pay its outstanding long-term debts. A ratio of 0.5 or less is generally considered good, with 0.3 or less usually being excellent. However, a low ratio can also mean the company has unstable revenue.
Higher ratios may mean the company has trouble paying its debts or will need a consistent revenue stream to pay off its debts and remain solvent. Most investors and lenders consider high long-term debt ratios risky.
The advantages of paying over long periods of time
Choosing to use long-term debt and paying off your liabilities over periods that last over a year has some advantages. Both businesses and individuals can utilize long-term liabilities to make monthly payments more affordable and to provide more financial flexibility.
Payments can be more affordable
One advantage of using long-term liabilities is that regular payments are more affordable than short-term loans. Because the repayment of your debt will last 12 months or longer, your minimum monthly payments will be lower. Lower monthly payments can free up your budget for spending in other areas and take pressure off of you to meet expensive financial responsibilities each month.
Utilizing the lower monthly payments of long-term debt can also be a fantastic way to get a handle on your debt. While some great solutions for paying off short-term liabilities with high monthly payments exist, like the debt snowball or debt avalanche methods, taking out a long-term loan to consolidate your short-term debt can be just as helpful.
A debt consolidation loan is a type of long-term debt where you concentrate many short-term liabilities into one convenient place.
Another reason debt consolidation is a popular debt reduction method is that you may be able to take your high-interest liabilities like credit card debts and move them into one loan with a lower interest rate that you will pay off over a more extended period of time.
Having the choice of paying off debt sooner
A long-term liability comes with the flexibility to pay off your debt earlier than scheduled. While you must make the minimum payments due, you can add extra or larger payments to reduce your principal faster. Paying off your long-term debts sooner can free up capital for other investments and obligations.
Early payments to clear your debt are also a way to improve your credit score. The less debt you have, the lower your credit utilization score, which is the amount of credit you have available. If your credit utilization score is high, meaning you do not have much credit available, lenders may think you aren't in control of your financial situation. A low credit utilization score signals to lenders that you are not overspending and can manage your debt responsibly.
The drawbacks of paying longer
Just as there are advantages to taking on long-term liabilities, there are disadvantages. Some drawbacks to long-term debt include an increase in interest overall and a lengthy financial commitment.
More interest accrues
Even though long-term debts come with lower monthly payments, you will pay more interest in the long run than short-term debt. Because you make the payments over a long period, more interest will accrue, and you will pay more overall. Paying lower monthly payments means that less of your payment goes toward the principal amounting to greater total interest costs.
It’s a lengthy financial obligation
Another drawback of taking on long-term debt is that it will curb your financial flexibility in some ways. While lower monthly payments allow for more spending in other areas, long-term liabilities will handicap part of your budget for the length of your repayment plan. Taking out a long-term loan and immediately attaining capital will be beneficial when you take on the debt. However, dedicating a set amount of cash towards repayment over a lengthy period will limit your ability to buy into new investment and growth opportunities.
What to consider when taking on long-term debt
Before deciding to take on long-term debt, consider how it will affect your future financial outlook. You also must create a budget to make sure you can meet your financial responsibilities.
Your repayment capacity
Your repayment capacity is your ability to repay any debts that you take on. Taking on more debt than you can repay can have a disastrous impact on your financial health, including negative items on your credit report, a lower credit score or even bankruptcy. It is essential to understand your repayment capacity by drafting a budget for the term of your liability.
Another thing to consider is whether your loan will have a prepayment penalty. Prepayment penalties are fees a lender charges for paying off all or some of your liability too quickly. Lenders may write these fees into the loan agreement, so it is crucial to be aware of them. Often, prepayment penalties will start as a percentage fee of the outstanding principal balance and decrease to zero as the length of the liability continues.
Avoiding prepayment penalties is ideal but sometimes tricky. If you have the cash needed to pay off the amount of your debt, you may want to wait until the prepayment penalty is no longer in effect to avoid paying extra fees. You can also negotiate with the debt collector directly to come up with a resolution or avoid loans that charge prepayment penalties.
Payment of principal vs. interest
The principal of a loan is the original amount that a lender issues to you. An interest rate is applied to the principal to determine how much extra you need to pay each month as a fee. When you submit a payment for a debt, your payment first goes toward the interest and fees accrued before affecting the principal amount you need to pay back.
The more you can put toward paying off your principal, the less interest you will accrue overall. It is, therefore, vital to consider the terms of your repayment agreement and interest rate. Finding the best combination of monthly payment amounts and term length can save you a lot of money in the long run.
The overall costs
Finally, calculate what your overall cost will be. While you may be able to budget for monthly payments, consider how much you will pay in total with all of the interest accrued over your repayment period. Don’t take on a long-term maturity unless you are comfortable with the overall amount you will pay.
Short-term debt vs. long-term debt
Whereas long-term debt lasts 12 months or longer, short-term debt can last from a few months up to one year. Both maturities can be advantageous depending on your financial goals and situation.
Borrowers need to repay short-term loans quickly, meaning the loan amounts are often less than long-term loans. At the same time, the longer the loan term, the more likely the borrower will be unable to repay the debt. Because you pay off a short-term liability quickly, there is less risk for the lender than long-term liabilities. With less risk, getting approved for a short-term loan may be easier.
Short-term loans often come with lower interest rates but higher monthly payments than long-term loans. Each monthly payment cuts down the principal amount at a much higher percentage, meaning you accrue less interest overall. The total amount you will pay for a short-term loan will be less than a long-term loan.
Note that not all short-term debt comes with a low-interest rate. According to investor.gov, most credit cards have high interest rates of 18% or higher. Those high interest rates can make it more challenging to pay off your credit card principal.
Is long-term debt the better debt?
Long-term debt is a better option if you want to spread your payments out over a lengthy period of time and make low monthly payments. Remember that your interest rates will be higher than if you use short-term debt and will pay a higher overall cost. Choosing between long-term or short-term debt ultimately depends on your financial goals and flexibility.