Debt extinguishment terminates the contract and is used to normalize contractual relations in consumer and business transactions. Debt extinguishment is happening when you pay all your debt or replace it by another debt instrument. This term refers, among others, to the process of removing a liability from the company's balance sheet and also from personal finances. Earlier extinguishment of debt occurs when the enterprise recovers the debt or when the repayment is made in-substance.
Types of debt
Types of debt (P. Colla, F. Ippolito, K. Li 2013, p. 2122):
- term loans are a cash loan which pays off for a certain period of time in regular installments, usually they last from 1 to 10 years, rarely up to 30 years,
- commercial paper these are money-market securities that are sold by large companies to raise funds to cover short-term liabilities,
- capital leases is a long-term contract not subject to cancellation, consisting in the transfer of ownership from the lessor to the lessee after the end of the lease period,
- drawn credit lines this type of loan is "on demand", if you meet the relevant criteria you can use it to the maximum amount, but only for a limited time,
- senior bonds and notes these are debt securities, their holders will be the first to be repaid in the event of liquidation of the company. That is why senior bonds and notes take precedence over other debts,
- subordinated bonds and notes are an unsecured loan. Creditors with this type of loan are repaid last, which is why it is often called.
Popular methods of paying off debt
We distinguish two methods of paying off debt:
- Debt snowball
- Debt avalanche
Debt snowball - D. Ramsey describes this method as a metaphor for the snowball, which gradually grows as it rolls downhill. Debtors should sort their debts from the smallest to the largest and then pay them off in that order. So the money from the smallest debt previously paid off is then rolled on next debt. This pattern is repeated until the last debt is paid off (D. Ramsey 2009, p. 109).
Debt avalanche - an effective method of paying interest-bearing debt by paying off consumer debts arranged from the lowest to the highest interest rate. This method allows the debtor to eliminate first the debts with the highest interest, while reducing the total repayment time (E. McAllister 2018, p. IV).
Mathematical analysis indicates that the most effective way to pay off a debt is the "Debt avalanche" method, but the most popular and independent of the interest rate is the "Debt snowball" method. The second strategy is a faster way to pay off the debt, but the first strategy favors the debtor's mental satisfaction, because repayment of a smaller loan is more encouraging than repayment of a larger one (E. McAllister 2018, p. 14).
- Bartov E., Mohanram S. P. (2014), Does Income Statement Placement Matter to Investors? The Case of Gains/Losses from Early Debt Extinguishment. The Accounting Review, Vol. 89 No. 6, p. 2021-2055.
- Colla P., Ippolito F.,Li K. (2013), Debt Specialization. The Journal of Finance, Vol. LXVIII No. 5, p. 2117-2141.
- Lange D. C., Fornaro M. J. ,Buttermilch J. R. (2013), Restructurings in Nontroubled Situations: Carefully Navigating the Relevant Guidance. The CPA Journal, Vol. April 2013, p. 26-35.
- McAllister E., (2018), A snowball's chance: Debt snowball vs. debt avalanche James Madison University, p. IV-14.
- Ramsey D. (2009), The Total Money Makeover: A Proven Plan for Financial Fitness, Thomas Nelson, Nashville, Tennessee, p. 109-133.
Author: Anna Machniak