What is Effective Debt?

Also known as outstanding debt or an overall debt load, effective debt is the total net amount of debt obligations currently carried by a business or individual. Just about any type of debt is included in this overall assessment of money owed to creditors, including bond issues, loans, and credit card balances. Since effective debt also includes regular payments made on various debt obligations, it is considered to be more inclusive and a more accurate picture of the true financial situation of the company or household.

One of the main benefits of effective debt is that calculating this amount makes it possible to determine the true net worth of an individual or company. This is important, since that net worth is a strong indicator of that entity’s ability to repay current debt obligations. The idea is that even if the revenue stream generated by the entity were to cease immediately, there are still enough assets that could be liquidated and used to settle all debt obligations. When this is the case, the individual or business is considered to be relatively stable, a factor that may be especially important to anyone seeking to invest in the business or extend a loan to the individual.

Understanding the current level of effective debt is also important to the process of creating and following a budget that makes it possible to honor all debt obligations. Not only is this helpful in terms of matching income generation to the retirement of debt overall, it also aids in determining how long it will take to pay off each debt according to terms. This is managed by determining what percentage of monthly income is necessary to make timely payments, and at what point funds allocated to pay off a specific debt can be redirected to settle another debt. This means that rather than creating a budget that simply makes it possible to manage debt from month to month, assessing effective debt aids in making long-term budget decisions that ultimately retire debt in the most efficient and cost-effective manner.

Assessing the current level of effective debt from time to time can also make it possible to minimize the chances for a business or individual becoming overextended. By periodically determining the total outstanding debt load as it stands on a given date, steps can be taken to delay unnecessary purchases until the debt is back under a certain amount. This may also involve changing the allocation of funds to a given debt, and in general reorder the repayment strategy so that the debt load is continually reduced rather than increased. In households, evaluating effective debt now and then can make it easier to refrain from using credit cards to purchase items that are wanted but not needed, or failing to note that the variable interest rate on the mortgage has increased, necessitating some changes in the accumulation of more debt if the budget is to remain balanced.