If you’re looking to understand the difference between debt investment and equity investment, you’re at the right place.
Debt and equity are great investment instruments you can leverage to earn high returns, make a stable periodic income, and build wealth. However, both asset classes offer different benefits and drawbacks.
Therefore, this article discusses the difference between debt and equity investments to help you make a better decision.
What is Debt Investment?
Debt investment is an investment where you lend money to an entity, such as a government, company, or individual, in exchange for the repayment with interest over an agreed period. You can make this investment through debt instruments like bonds, treasury bills, certificates of deposits (CDs), or promissory notes.
Debt investments are crucial elements of an investment portfolio. They provide you with stability, fixed income, and risk diversification benefits. If you’re looking to preserve your capital while getting a steady income, investing in debt instruments is the way to go.
What is Equity Investment?
Equity investment involves buying shares or ownership stakes in a company. This kind of investment makes you a part owner of the company.
As an equity investor, also known as a shareholder or stockholder, the value of your investment in a company depends on the company’s performance. This means you’d share in the company’s profits and losses and receive dividends if it’s a dividend-paying company.
The Difference between Debt and Equity Investment
Debt and equity investments are two ways you can put your funds to good use and receive handsome rewards. Understanding their differences will help you determine which one is more suitable for your risk appetite and whether to diversify your funds across both asset classes.
Here are the key differences between debt and equity investments:
1. Nature of the Investment
Understanding the differences between debt and equity investments starts with understanding the nature of each investment.
In debt investments, you lend money to a government, company, or individual and get periodic interest payments and the repayment of the full principal at the maturity of the loan.
However, in equity investments, you buy the shares of a company to become a part owner. You receive returns on your investment based on the performance of the company and the amount of shares you bought. That means you take part in the company’s profit and losses in the same capacity as the amount of the company’s shares in your portfolio.
2. Ownership and Control
As a debt investor, you don’t have ownership rights or voting privileges in the borrowing company. However, you have a legal claim on the company’s assets and cash flows and can take possession of them in case of defaults in your payment.
On the other hand, as an equity investor, you’re a part owner of the company and, as such, have voting rights in shareholder meetings. Equity investors can influence decisions in a company with their voting power.
3. Risk
All investments have a level of risk. However, equity investments are riskier than debt investments.
Debt investments are generally less risky than equity investments because they have a higher priority of repayment in case of bankruptcy or financial distress. When a company or project fails, creditors are usually paid first before shareholders.
Equity investments are riskier than debt investments because their returns are dependent on the success and profitability of the company. You can lose your investment when a company or project fails.
4. Return
The saying, “the higher the risk, the higher the return,” plays out in the difference between debt and equity investments.
Returns on equity investments are often higher than that of debt investments, as equity investments have a higher level of risk.
In debt investments, the risk is less, and as such, the return is lower. While you still stand a chance of losing your investment due to defaults, you have a chance of recovering them. The collateral can be liquidated, and all creditors will be paid off first.
5. Holding Time
Another difference between debt and equity investments is their holding time or maturity periods.
Debt investments are usually short-term investments with a fixed maturity period of a few years. You can invest in a debt instrument and have your return within 6 months and 5 years.
However, in equity investments, there’s no fixed maturity date. Investments can last up to years before you can see a profitable return from them, as stocks tend to do better in the long run.
6. Priority of Payments
Debt investors are prioritized over shareholders when making payments. Debts are often paid off first before profit or loss sharing. And in case of bankruptcy or liquidation, debt investors are settled before equity investors.
Equity investors are residual claimants. This means, as an equity investor, you receive payments after all debt holders have been paid. If a company liquidates, the equity holders are entitled to the remaining assets after all debts have been settled.
Pros and Cons of Debt and Equity Investments
Here are the Pros and Cons of debt and equity investments:
Pros of Debt Investments
- Debt investments offer a more stable income and cash flow
- Less risky than equity investments
- Ensures capital preservation
- Offers huge diversification opportunity to a portfolio
- Short-term debt instruments are highly liquid
Cons of Debt Investments
- Lower returns compared to equity investments
- No ownership or voting rights in the company
- Exposed to credit risk
Pros of Equity Investments
- Offers a much higher return on your investments
- Offers ownership and voting rights
- Profits made from rental income and capital appreciation
- Investing in equities of different sectors can enhance diversification
Cons of Equity Investments
- Higher risks on investments
- No income guarantee
- Equity markets are highly volatile, which could lead to losses.
- Lack of priority in payment, unlike debt investments.
Debt and Equity Investment: Which is Right for You?
Both debt and equity investments have their benefits and drawbacks. While debt investments offer you more income stability and capital preservation, equity investments offer you the potential for higher returns, ownership stakes in the company, and a chance to participate in the growth of the company.
Therefore, if you’re looking to earn a steady income with a lesser risk on your capital, debt investment is the right option for you. However, if you’re looking to earn higher returns and don’t mind the risk involved, then investing in equities is the way to go.
You can also own a portfolio of both asset classes to diversify your risk and increase your chances of earning higher returns.
