Reviewed by Erika Rasure

According to the U.S. Bureau of Economic Analysis (BEA), total production in the U.S. economy grew at a 2% clip in the third quarter of 2015. In the second quarter, real gross domestic product (real GDP) was revised up to 3.7% growth. There are some problems with relying on GDP to gauge economic health, but these were still encouraging signs for a country fighting through the slowest post-recession recovery in its history.

Positive economic numbers only added to expectations about a potential interest rate hike by the Federal Reserve heading into 2016. The Fed had not raised interest rates since before the Great Recession.

A momentous 0.25% federal funds rate hike is only one challenge that the U.S. economy faced in 2016. Labor force participation was still historically low. Politicians continued to rack up enormous deficits and finance them with cheap credit. And the entire global financial system teetered because China’s economy finally slowed after years of ravenous growth.

The following are three challenges that American businesses and policymakers confronted in 2016.

Key Takeaways

• U.S. businesses and policymakers confronted three significant economic challenges in 2016.
• The Federal Open Market Committee (FOMC) raised the federal funds rate by 0.25% in December 2016, after holding steady as inflation remained below target.
• The struggles of the two largest foreign markets, Europe and China, affected the U.S. economy.
• The U.S. economy added jobs, but very few were full-time, productive jobs in the private economy.

The Fed’s Difficult Balancing Act

The Federal Open Market Committee (FOMC) openly toyed with the idea of raising interest rates beginning in at least 2012. The Fed likely did not raise them for much of 2016 because it was caught between a rock and several hard places.

There is ample historical evidence to suggest low interest rates fuel bond, equity, and housing prices. The opposite tends to occur when rates increase. The 2015 recovery was likely built on higher asset prices and lower energy costs. There were concerns that raising interest rates would not cause oil prices to jump, but would also drive down assets, turning the small recovery into a contraction.

Then again, interest rates couldn’t stay at zero forever. The economy had already suffered the terrible results of unchecked housing and stock market growth in 2007–2008, and the Fed did not want to double down on that mistake. Additionally, savers and retirees had been crippled by record-low payments on traditional income devices such as certificates of deposit (CDs) and bonds.

Just as critically, the federal government did not want rates to rise. First, the illusory growth from low interest rate policies was politically popular. Second, the United States had an enormous interest payment on the debt. These interest payments suddenly get much larger when the government has to issue new bonds with higher coupons.

In December 2016, the FOMC finally raised the fed funds rate by 0.25%.

Weakness in Europe and China

The U.S. is not immune to the ebbs and flows of a complex global economy, and the two largest foreign markets, Europe and China, struggled in 2016. When the Shanghai Stock Exchange Composite more than doubled from October 2014 to August 2015, many pronounced China as the economic superpower of the future. That optimism all but disappeared in a flash after Chinese equities fell by nearly 40% over the next two months, despite massive purchases of failing companies by the Chinese Security Finance Corp.

It turns out China had a real estate and stock market bubble that felt disturbingly similar to the American experience in 2007–2008. The “red economy,” seemingly impervious to a slowdown the year prior, seemed on the brink of a multiyear struggle.

News out of Europe was not much better. Recorded growth in the eurozone was just 0.5% in Q1 2015, and numbers were even worse for Q2 and Q3. Germany and the United Kingdom had been reluctantly dragging the rest of the continent out of the red for years, but economic and political concerns were numerous in the new year.

Sluggish Jobs Market

The U.S. economy added jobs each month in 2015. This is the good news. The bad news was that very few of those jobs were full-time, productive jobs in the private economy. The middle class was still struggling, and the economy did not seem well equipped to provide new, lasting, and high-paying opportunities.

Total government employment increased by more than 1.1 million from November 2014 to November 2015. Over the same time frame, over 500,000 jobs were added to an increasingly bureaucratic healthcare sector. And, as the November 2015 jobs report from the U.S. Bureau of Labor Statistics pointed out, “the number of persons employed part-time for economic reasons (sometimes referred to as involuntary part-time workers) increased by 319,000 to 6.1 million.”

The labor force participation rate was near decade-long lows all year, standing at under 63%. And, even though 211,000 jobs were added in November 2015, there were 2.3 million workers only “marginally attached to the labor force” or who were discouraged and not believing there were jobs out there for them. This means that, by a factor of eight-to-one, more people gave up looking for jobs than found them.

U.S. unemployment held steady for much of 2016 before falling 0.3% in Q4.

How Much Did the Economy Factor into the 2016 Presidential Election?

The economy was a top issue for voters in the 2016 U.S. presidential election, which Donald Trump won. According to a Pew Research Center survey in June 2016, 84% of registered voters said that the issue of the economy would be very important to them in deciding who to vote for.

What Was the Final Result for the U.S. Economy in 2016?

The U.S. economy grew by 1.6% in 2016, according to real GDP figures from the Bureau of Economic Analysis. This was a decline from a 2.6% increase in 2015.

What Challenges Will the U.S. Economy Face in 2025?

Challenges facing the U.S. economy in 2025 include:

• A shrinking trend of more job openings than people searching for work
• Two possible cuts to the federal funds rate, reflecting Federal Reserve recognition that the inflation rate is falling slower than expected and a possible hedge against new tariffs from the second Trump presidential administration
• Tax cuts, as promised by the Trump administration, that would keep the federal budget deficit high

The Bottom Line

American businesses and policymakers confronted three significant economic challenges in 2016. One was the Federal Open Market Committee (FOMC) toying with raising interest rates, before finally doing so in December 2016. The second was the struggles of the two largest foreign markets: Europe and China. The third was a sluggish jobs market in which very few of the jobs being added represented full-time, productive work in the private economy.

Reviewed by Cierra Murry

Despite their infamous reputation for their role in the financial crisis of 2007-2008, there are several different arguments in favor of allowing market participants to trade and own mortgage-backed securities (MBS).

At its basic level, an MBS is any investment solution that uses commercial or residential mortgage or a pool of mortgages as the underlying asset. Like most financial innovations, the purpose of an MBS is to increase return and diversify risk. By securitizing pools of similar mortgages, investors can absorb the statistical likelihood of non-payment.

However, an MBS is a complicated instrument and comes in many different forms. It would be difficult to asses the general risk of an MBS, much like it would be difficult to assess the risk of a generic bond or stock. The nature of the underlying asset and the investment contract are large determinants of risk.

Advisor Insight

• Mortgage-backed securities(MBS) are tradeable securities backed by the cash flow from a portfolio of mortgages.
• In theory, MBS diversify risk by providing access to a broad portfolio of mortgage debt.
• Mortgage-backed securities played a key role in the 2008 financial crisis when many of the underlying loans defaulted.
• Today, mortgage-backed securities are still popular among investors seeking diversified exposure to real estate lending.

Improved Liquidity and Risk Argument

Mortgage debt and pools of mortgages are sold by financial institutions to individual investors, other financial institutions and governments. The money received is used to offer other borrowers loans, including subsidized loans for low-income or at-risk borrowers. In this way, an MBS is a liquid product.

Mortgage-backed securities also reduce risk to the bank. Whenever a bank makes a mortgage loan, it assumes risk of non-payment (default). If it sells the loan, it can transfer risk to the buyer, which is normally an investment bank. The investment bank understands that some mortgages are going to default, so it packages like mortgages into pools. This is similar to how mutual funds operate. In exchange for this risk, investors receive interest payments on the mortgage debt.

Suggesting that these types of MBS are too risky is an argument that could apply to any type of securitization, including bonds and mutual funds.

Aggregate Arguments: Consumption Smoothing and More Homes

Economic research has suggested that, in both domestic and international markets, the securitization of the mortgage market has led to the sharing of consumption risk. This allows banking institutions to supply credit even during downturns, smoothing out the business cycle and helping normalize interest rates among different populations and risk profiles. Theoretically, the level of consumer spending in the market is smoother and less prone to recession/expansion fluctuations as a result of increased securitization.

The unquestioned result of mortgage securitization has been an increase in home ownership and a reduction in interest rates. Through the MBS and its derivative, the collateralized mortgage obligation, banks have been more able to provide home credit to borrowers who otherwise would have been priced out of the market.

$1.59 trillion

The total value of mortgage-backed securities issued in the U.S. in 2024.

Federal Reserve Involvement

While the MBS market draws a number of negative connotations, the market is more “safe” from an individual investment stand point than it was pre 2008. After the collapse of the housing market, and on the back of strict regulation, banks increased the underwriting standards and made their loans more robust and transparent. 

The Federal Reserve remains a big player in the MBS market. As of Feb. 2025, the Fed’s balance sheet included $2.2 trillion in MBS. With the central bank a significant player, the MBS market has clawed back much of its credibility. 

Free to Contract Argument

There is another argument in favor of allowing MBS that has less to do with financial arguments and more to do with the nature of capitalism itself: Capitalism is a profit and loss system, built on the argument that voluntary exchange and individual determination are ultimately preferable to government restrictions. Nobody coerces a borrower into taking out a mortgage loan, just as no financial institution is legally obligated to make additional loans and no investor is forced to purchase an MBS.

The MBS allows investors to seek a return, lets banks reduce risk and gives borrowers the chance to buy homes through free contracts.

What Are the Risks of Mortgage-Backed Securities?

There are three main risks for investors in mortgage-backed securities: interest rate risk, prepayment risk, and default risk. Interest rate risk refers to the chance that market-wide interest rates will increase, thereby reducing the market value of existing contracts. This is common to all fixed-income investments, not just MBS. Prepayment risk is the possibility that some borrowers will pay off their loans early, thereby reducing the total income for MBS holders. Default risk is the possibility that a large number of borrowers will default, thereby reducing the investors’ income stream.

How Did Mortgage-Backed Securities Contribute to the Financial Crisis?

Prior to the 2008 financial crisis, many banks and lenders chose to securitize their mortgage assets and sell them, rather than keep those loans on their own balance sheets. As the housing bubble inflated, lenders began to lower their lending standards, and used mortgage-backed securities as a convenient way to dispose of high-risk loans. When borrowers started to default, MBS investors were left with underperforming assets.

How Big Is the Market for Mortgage-Backed Securities?

The market for mortgage-backed securities is significant. In 2024, nearly $1.6 trillion of mortgage-backed securities was issued in the United States. The largest component was Agency MBS, issued by government-affiliated bodies like Ginnie Mae.

The Bottom Line

Although mortgage-backed securities(MBS) are commonly associated with the 2008 housing crash, they are still a popular choice for institutional investors. By bundling together a large number of loans, these securities provide investors with broad exposure to a large portfolio of loans, rather than betting on the solvency of a single borrower. Moreover, they also have the effect of smoothing out regional and demographic variations in mortgage interest rates.

Investors around the globe are increasingly worried about the state of China’s economy—the world’s second-largest economy after the United States—which has been severely impacted by rising credit levels, a slowdown in its gross domestic product (GDP), and the ongoing trade war with the U.S.

Very few economies have grown at the rate of China’s; according to The World Bank, the growth rate of China’s economy over the past 30 years has averaged about 9% per year. However, China’s GDP growth in 2020 was 2.2%, the slowest year since 1990. Accelerating credit growth, the overvaluation of the yuan, and a frothy housing market have contributed to a slowdown in the second-biggest economy in the world.

Key Takeaways

• Investors around the globe are increasingly worried about the state of China’s economy, which has been severely impacted by rising credit levels, a slowdown in its gross domestic product (GDP), and the ongoing trade war with the U.S.
• China’s GDP growth in 2020 was 2.2%, the slowest year since 1990.
• Accelerating credit growth, the overvaluation of the yuan, and a frothy housing market have contributed to a slowdown in the second-biggest economy in the world.
• If China’s troubles persist, there could be significant consequences for foreign trade, financial markets, and economic growth in the U.S. and around the world.

Accelerating Credit Growth

Economists Wei Yao and Claire Huang of Société Générale consider that much of the growth in China’s economy was due to credit expansion. In an attempt to shift from an investment-based to a consumption-based economy and reverse the 25-year trend of slowing economic growth, the Chinese government adopted an accommodative monetary policy.

From 2016 to 2024, China’s overall debt soared from 242% to 303% of its GDP. In an attempt to alleviate its supply of debt, China has tried to increase demand by easing restrictions on market entrance for foreign investors. These efforts have achieved little success. Theoretically, when bond markets become more accessible, foreign investor demand should increase. However, there hasn’t been any data to support an increased level of investor interest in Chinese bonds.

Overvalued Currency

In addition to its credit woes, China is facing a currency crisis. Through excessive debt creation and money printing, the People’s Bank of China (PBOC) has created one of the largest money supplies and total banking system assets of any country. An aggressive monetary policy has led to total banking system assets of $60.59 trillion (439.52 trillion yuan) at the end of the third quarter of 2024. From 2010 to 2017 alone, the total assets of banking institutions in China increased by over 200%. This has contributed to an overvalued yuan.

Perhaps even more concerning are the statistics about China’s total social financing (TSF). Total social financing reflects an economy’s credit level, taking into account off-balance-sheet financing, or “shadow banking,” including initial public offerings (IPOs), loans from trust companies, and bond sales. As of January 2025, China’s total outstanding TSF was $973.2 billion. This is an indication that debt growth is accelerating via China’s shadow banking system.

Frothy Real Estate Market

After the loss of $3.2 trillion during China’s stock market crash in 2015, the PBOC attempted to encourage potential equity investors. Compared to Americans, the Chinese have historically invested more of their capital in real estate than in the financial markets. The 2015 stock market crash reinforced that trend; Chinese direct investment in the United States that year hit a record $15.7 billion.

In 2024, the median price per square foot for real estate in China was about $238, almost 6% higher than the median price per square foot of real estate in the U.S. that year ($225), despite the fact that per-capita income in the U.S. was 1,670% higher than China in 2023, the most recent year for which annual data is available. This housing data indicates that, for a time, the Chinese continued to invest in real estate for their economic growth. Historically, real estate has been the main driver of growth in China’s economy, accounting for a large portion of its GDP. China’s efforts to float its housing market, keeping prices rising and continuing development, might have hurt other areas of its economy.

Housing prices have been falling in China since the third quarter of 2021, according to the U.S. Federal Reserve. In May 2024, China rolled out its strongest measures so far to fix its broken housing market, easing mortgage rules and pushing city and local authorities to buy up unsold homes to be converted into affordable housing. Before this, policymakers tightened policies in order to crack down on speculative buying that had been prevalent since 2015. Before the downturn, housing prices were consistently rising in every major city for several years, although income level lagged.

How Is the Chinese Economy Structured?

China has a socialist market economy. This means that it has both state-owned enterprises and a market economy. China’s communist government plays a significant role in the economy, guiding development with five-year plans.

What Is the Status of the U.S.-China Trade War?

On Feb. 1, 2025, U.S. President Donald Trump ordered 10% tariffs on China, which took effect three days later. China responded with duties on the imports of some American goods and an antitrust probe into Alphabet’s (GOOGL) Google. Trump said he imposed the tariffs over China’s role in the flow of fentanyl, a powerful synthetic opioid, into the U.S.

What Is the Forecast for China’s Economy?

China’s economy in 2025 is expected to see slower growth, with most forecasts predicting a rate around 5% or below. This is mostly due to weak consumer demand, a struggling real estate market, and high debt levels, despite the government’s attempts to stimulate domestic consumption through policy changes.

The Bottom Line

China’s economic situation can be difficult to assess. While China has taken steps toward becoming more transparent in its financial sector, its GDP data is known to have been manipulated in the past. Some economists and analysts speculate that official data about Chinese industrial profits are also manipulated and do not reflect the true state of the economy. It’s likely that China’s economy is underperforming compared to government reports.

If China’s troubles persist, there could be significant consequences for foreign trade, financial markets, and economic growth in the U.S. and around the world.

Fact checked by Yarilet Perez
Reviewed by Natalya Yashina

Balance of Payments Overview

A country’s balance of payments (BOP) is the record of all international transactions (payments and receipts) between the individuals and entities (including government) of that nation and other countries during a specific time period.

The current account, the capital account, and the financial account make up a country’s BOP. Together, these three accounts tell a story about a country’s economy, economic outlook, and strategies for achieving its desired goals.

For example, a large volume of imports and exports may indicate an open economy that supports free trade.

On the other hand, a country that shows little international activity in its capital or financial account may have an underdeveloped capital market and little foreign currency entering the country in the form of foreign direct investment (FDI).

Current, Capital, and Financial Accounts

A current account records the flow of goods and services in and out of a country, including tangible goods, service fees, tourism receipts, and money sent directly to other countries either as official aid or family to family funds.

The capital account measures the capital transfers between U.S. residents and foreign residents.

A financial account measures the increase or decrease in a country’s ownership of international assets.

In this article, we focus on the capital and financial accounts, which reflect investment and capital market regulations within a given country.

Key Takeaways

• A country’s balance of payments is represented by its current account, capital account, and financial account.
• The current account records the flow of goods and services in and out of a country (imports and exports).
• The capital account measures the capital transfers between U.S. residents and foreign residents.
• The financial account reflects increases or decreases in a country’s ownership of international assets.
• Positive capital and financial accounts mean a country has more debits than credits and is a net debtor to the world; negative capital and financial accounts make the country a net creditor. 

The Capital Account

A country’s capital account records all international capital transfers. The income and expenditures are measured by the inflow and outflow of funds in the form of investments and loans.

A deficit shows that more money is flowing out, while a surplus indicates that more money is flowing in.

Along with non-financial and non-produced asset transactions, the capital account includes:

• Dealings such as debt forgiveness
• The transfer of goods and financial assets by migrants leaving or entering a country
• The transfer of ownership of fixed assets and of funds received for the sale or acquisition of fixed assets
• Gift and inheritance taxes
• Death levies, patents, copyrights, royalties
• Uninsured damage to fixed assets

Complex transactions involving both capital assets and financial claims may be recorded in both the capital and current accounts.

The Financial Account

Sub-Accounts and Their Effects

A country’s financial account can be broken down into two sub-accounts. One is the domestic ownership of foreign assets. The other is the foreign ownership of domestic assets. Together, these two sub-accounts measure a country’s ownership of international assets.

If the sub-account for the domestic ownership of foreign assets increases, the overall financial account increases.

If the sub-account for the foreign ownership of domestic assets increases, the overall financial account decreases.

Thus, the overall financial account increases when the foreign ownership of domestic assets sub-account decreases.

Together, these two sub-accounts of the financial account measure a country’s ownership of international assets.

The financial account deals with money related to:

• Foreign reserves
• Private investments in businesses, real estate, bonds, and stocks
• Government-owned assets such as special drawing rights at the International Monetary Fund (IMF)
• Private sector assets held in other countries
• Local assets held by foreigners (government and private)
• Foreign direct investment

How the Capital and Financial Accounts Work

Capital transferred out of a country for the purpose of investing in a foreign country is recorded as a debit in either of these two accounts.

Specifically, if it’s a portfolio investment, it’s recorded as a debit in the financial account. If it’s a direct investment, it’s recorded as a debit in the capital account.

Since these transfers involve investments, there’s an implied return. In the BOP, this return is recorded as a credit in the current account.

The opposite is true when a foreign country earns a return. Paying a return on an investment would be noted as a debit in the current account.

Important

The U.S. Bureau of Economic Analysis records and provides information to the public about the current account, capital account, and financial account balances.

Understanding the Balance of Payments

Accounts in Balance

Unlike the current account, which theoretically is expected to run at a surplus or deficit, the BOP should be zero. Thus, the current account on one side and the capital and financial account on the other should balance each other out.

For example, if a Greenland national buys a jacket from a Canadian company, then Greenland gains a jacket while Canada gains the equivalent amount of currency. To reach zero, a balancing item is added to the ledger to reflect the value exchange.

According to the IMF’s Balance of Payments Manual, the balance of payment formula, or identity, is summarized as:

Current Account + Financial Account + Capital Account + Balancing Item = 0

Positive Capital and Financial Accounts

However, when an economy has positive capital and financial accounts it has a net financial inflow. The country’s debits are more than its credits due to an increase in liabilities to other economies or a reduction of claims in other countries.

This is usually in parallel with a current account deficit—an inflow of money means the return on an investment is a debit on the current account.

Thus, the economy is using world savings to meet its local investment and consumption demands. It is a net debtor to the rest of the world.

Negative Capital and Financial Accounts

If the capital and financial accounts are negative, the country has a net financial outflow. It has more claims than it does liabilities, either because of an increase in claims by the economy abroad or a reduction in liabilities from foreign economies.

The current account should be recording a surplus at this stage. That indicates the economy is a net creditor, providing funds to the world.

Liberal Accounts

The capital and financial accounts are intertwined because they both record international capital flows. In today’s global economy, the unrestricted movement of capital is fundamental to ensuring world trade and eventually, greater prosperity for all.

For this flow to happen, countries must have open or liberal capital account and financial account policies.

Today, many developing economies implement capital account liberalization as part of their economic reform programs. This removes restrictions on capital movement.

Note

Liberalization of a country’s capital account may signal a shift toward more open economic policy.

Benefits of Foreign Direct Investment

This unrestricted movement of capital means governments, corporations, and individuals are free to invest capital in other countries. That can pave the way for not only more FDI in industries and development projects. It can also allow for more portfolio investment in the capital market as well.

Thus, companies striving for bigger markets, and smaller markets seeking more capital and the achievement of domestic economic goals, can expand into the international arena. This can result in a stronger global economy.

The benefits that the recipient country reaps from FDI include an inflow of foreign capital into its country as well as the sharing of technical and managerial expertise. The benefit for a company making an FDI is expanding market share in a foreign economy and, potentially, greater returns.

Another benefit, according to some, is that a country’s domestic political and macroeconomic policies can take on a more progressive stance.

That’s because foreign companies investing in a local economy have a valued stake in the local economy’s reform process. These foreign companies can become expert consultants to the local government on policies that will facilitate businesses.

Other Benefits

Portfolio foreign investments can encourage capital market deregulation and boost stock exchange volume. By investing in more than one market, investors are able to diversify their portfolio risk. They can potentially increase their returns by investing in an emerging market.

A deepening capital market based on local economic reforms and a liberalization of the capital and financial accounts can speed up the development of an emerging market.

Capital Account Control Can Be Good

Some sound economic theories assert that a certain amount of capital account control can be good.

Example

Recall the Asian financial crisis in 1997. Some Asian countries opened up their economies to the world. An unprecedented amount of foreign capital crossed their borders.

Primarily, it was portfolio investment—a financial account credit and a current account debit. This meant short-term investments that were easy to liquidate.

When speculation increased, panic spread throughout the region. Capital flows reversed. Money was pulled out of these capital markets. Asian economies were responsible for their short-term liabilities (debits in the current account) as securities were sold off before capital gains could be reaped.

Not only did stock market activity suffer, but foreign reserves were depleted, local currencies depreciated, and financial crises resulted.

Analysts argue that the financial disaster could have been less severe had there had been some capital account controls.

For instance, had the amount of foreign borrowing been limited (debits in the current account), that would have limited short-term obligations. In turn, some degree of economic damage could have been prevented.

What Does the Balance of Payments Mean?

The term “balance of payments” refers to all the international transactions made between the people, businesses, and government of one country and any of the other countries in the world. The accounts in which these transactions are recorded are called the current account, the capital account, and the financial account.

Why Should an Economy Be Liberalized?

A more open or liberal economy can mean more international trade for a country. The income that results from that trade can benefit a country’s citizens. It could raise their standard of living. For a country as a whole, freer trade can raise its standing in the world and attract investors. That can open up all kinds of beneficial financial and economic opportunities.

What Is the Capital Account?

The capital account is one of the accounts used in the balance of payments. It’s used to record international transfers of capital between the residents in one country and those in other countries. The capital account can reflect a country’s financial health and stability. It can indicate how attractive a country is to other countries that seek to invest internationally.

The Bottom Line

A country’s balance of payments is a summarized record of that country’s international transactions with the rest of the world. These transactions are categorized by the current account, the capital account, and the financial account.

Lessons from the Asian financial crisis resulted in new debates about the best way to liberalize capital and financial accounts.

Indeed, the IMF and World Trade Organization historically have supported free trade in goods and services (current account liberalization). They are now faced with the complexities of capital freedom.

Experience has proven that without controls, a sudden reversal of capital flows can destroy an economy and result in increased poverty for a nation.

Fact checked by Vikki Velasquez
Reviewed by Erika Rasure

The major types of 401(k) plans are traditional 401(k)s and Roth 401(k)s. Smaller employers may offer you a SIMPLE (Savings Incentive Match Plan for Employees) 401(k) or a safe harbor 401(k) plan. If you’re an entrepreneur, you may be able to set up your own 401(k) account, too. These types of 401(k) plans have grown in popularity since the introduction of the 401(k) plan in the late 1970s and early ’80s. Nowadays, about 70 million workers participate in this type of retirement savings account. Learn more about these types of plans to decide which is right for you.

Key Takeaways

• Larger employers typically offer both traditional and Roth 401(k)s.
• Smaller employers may favor SIMPLE (Savings Incentive Match Plan for Employees) and safe harbor 401(k) plans, which can be less complex and less costly to administer.
• Solo entrepreneurs can set up a 401(k) just for themselves.

5 Types of 401(k)s and How They Work

All 401(k)s are defined contribution plans. They’re funded by employee contributions. Sometimes employers contribute, too.

With a 401(k), the amount of money that employees will have available for retirement is determined by how much they contributed to the plan and how well the investments in their account have performed over the years.

There are several different types of 401(k) plans. These are the ones you are most likely to encounter as either an employee or an employer. 

Traditional 401(k)

This is what most people probably think of as a 401(k). The employee contributes pre-tax money to their account each pay period, usually through regular payroll deductions. That money goes into the investments, typically mutual funds, that they’ve chosen from the plan’s offerings.

The maximum that employees can contribute is set by law. For 2025, it is $23,500 a year for anyone under age 50 or $31,000 for those 50 or older—unless you’re 60, 61, 62 or 63. In that case, you can contribute up to $34,750.

On top of that, many employers will make a matching contribution, such as 50 cents per dollar of the employee’s contributions, up to 6% of the employee’s salary.

With a traditional 401(k), the money that the employee contributes is not immediately taxed. Instead, the amount of their contribution lowers their taxable income for the year. So, for example, an employee who makes $50,000 a year and contributes $10,000 to their 401(k) plan will pay income taxes only on $40,000 of their income that year. The account’s earnings will also grow tax-deferred until they’re eventually withdrawn.

When the employee makes withdrawals (often referred to as distributions) from the account, that money will be taxed as regular income. In addition, because 401(k)s are intended for retirement, employees generally can’t withdraw money before age 59½ without paying a 10% early withdrawal penalty. There are, however, some exceptions to that rule.

Traditional 401(k) plans are also subject to required minimum distribution (RMD) rules. Account owners must take RMDs each year starting at age 73. (Your birth year may mean that your RMDs started earlier. Internal Revenue Service (IRS) Publication 590-B has tables and worksheets that you can use to calculate your RMDs.) 

Note

In addition to 401(k)s, other types of defined contribution retirement plans include 403(b) plans for schools and nonprofits, 457 plans for government workers, and profit-sharing plans in the corporate world.

Roth 401(k)

The Roth 401(k), sometimes called a designated Roth account, is like a traditional 401(k) but with one key difference: Contributions don’t receive an upfront tax break, but withdrawals will be tax free if the employee meets certain requirements. Specifically, they must generally be 59½ or older and have had the Roth account for at least five years; however, as with traditional 401(k)s, there are exceptions. Contributions to a Roth 401(k)—as opposed to the account’s earnings—can be withdrawn tax free at any time because they have already been taxed.

Some employers offer both traditional and Roth 401(k) options. Employees can, if they wish, split their contributions between the two types, but their maximum total contribution (in 2025) can’t exceed $23,500 a year for anyone under age 50 or $31,000 for those 50 or older—unless you’re age 60, 61, 62 or 63. In that case, you can contribute up to $34,750.

Roth 401(k)s were subject to the same RMD rules as traditional 401(k)s before 2024. Now, RMDs are no longer required from designated Roth 401(k)s during the account owner’s lifetime, per the SECURE 2.0 Act of 2022.

SIMPLE 401(k)

SIMPLE (Savings Incentive Match Plan for Employees) 401(k) plans are designed for businesses with 100 or fewer employees.

With a SIMPLE 401(k) plan, employees can contribute up to $16,500 (in 2025) if they’re under age 50 or $20,000 if they’re 50 or older. The exception is if you’re age 60, 61, 62 or 63. In that case, you can contribute up to $21,750. As with a traditional 401(k), that money isn’t taxed as income until it’s eventually withdrawn from the plan.

The employer must make either a matching contribution of up to 3% of each employee’s pay for those who contribute to the plan or a nonelective contribution of 2% for all eligible employees, regardless of whether they participate in the plan.

Like traditional and Roth 401(k)s, SIMPLE 401(k)s can be subject to early withdrawal penalties before age 59½ and to required minimum distributions after age 73.

Safe Harbor 401(k)

Safe harbor is a legal term for a provision in the law that exempts a person or company from certain regulations if they meet other requirements. A safe harbor 401(k) allows employers to skip the nondiscrimination tests that most 401(k) plans are subject to. Nondiscrimination tests are intended to ensure that plans do not discriminate in favor of highly-compensated employees in terms of employer matches or other benefits. Because safe harbor 401(k)s are easier to administer, they are especially popular with small businesses.

In return, employers with safe harbor 401(k)s must make annual contributions to every eligible employee’s plan, regardless of whether the employees themselves contribute. In addition, that money is immediately vested, regardless of how long the employee has been with the
company.

(Other types of 401(k) plans often have vesting requirements for their employer contributions, while employee contributions are always immediately vested.)

Employers can make their required contributions in one of three ways:

1. Nonelective contribution: The employer contributes an amount equal to 3% of compensation on behalf of each non-highly compensated employee. Employees are not required to contribute.
2. Basic match: The employer matches 100% of each non-highly compensated employee’s elective contributions, up to 3% of their compensation. Also, it matches 50% of the next 2% in compensation. So, for example, an employee who earns $50,000 a year would be eligible for a maximum match of $2,000 (100% of their first $1,500 in contributions plus 50% of the next $1,000).
3. Enhanced match: The employer can base its match on up to 6% of the employee’s compensation, rather than just 5%, as with a basic match.

Aside from those differences, safe harbor 401(k)s work much like any other 401(k) and are subject to the same rules on contributions, early withdrawals, and required minimum distributions.  

Warning

If you have multiple 401(k) plans, such as one with an employer and another for your own small business, your total contributions can’t exceed the maximum for a single 401(k) plan.

One-Participant 401(k) 

These plans go by a variety of names, including solo 401(k), individual 401(k), and self-employed 401(k). They are designed for businesses with no employees other than the owner, plus their spouse if that person also works in the business.

Because the owner is considered both an employer and an employee of the business, they can contribute to the plan in both capacities.

As employees, they can contribute up to 100% of their compensation or net income from self-employment, with the same annual contribution limit as traditional and Roth 401(k) plans: for 2025, it’s $23,500 a year for anyone under age 50 or $31,000 for those 50 or older. There’s an exception if you’re 60, 61, 62 or 63. If you are, you can contribute up to $34,750.

As their own employers, they can also make additional, nonelective contributions. The maximum depends on how their business is set up for tax purposes (S corporation vs. self-employed sole proprietor, for example).

In total, as employer and employee, the business owner can contribute as much as $70,000 to their 401(k) plan (for 2025), plus another $7,500 if they’re 50 or older (or $11,250 if they’re 60, 61, 62 or 63).

Spouses who earn income from the business can also contribute to a one-participant 401(k), up to the same maximums, and they are eligible for the same additional employer contribution.

One-participant 401(k)s can be either traditional or Roth plans and are subject to the same rules as those plans for early withdrawals and required minimum distributions.

Other Retirement Savings Vehicles

There are also other ways you can save for retirement. Individual retirement accounts (IRAs) offer a traditional option and a Roth option. You can open an IRA on your own with a broker and potentially get a tax deduction for contributing every year.

Additionally, your employer may offer a health savings account (HSA). An HSA is a place where you can save pre-tax money every month and use it for medical expenses. It’s often paired with a high-deductible health plan. It’s a tax-advantaged account that can be used as a retirement savings account. That’s because you can invest the funds in an HSA similar to how you would with a 401(k) or IRA. You can also leave the funds where they are and roll them over year to year if you don’t use them. And when you reach age 65, you can use the money in your HSA for other expenses, not just qualified medical expenses. (If you do so, however, you’ll pay income tax on those expenses.)

Can You Have Both a 401(k) Plan and an Individual Retirement Account (IRA)?

Yes, you can contribute to both a 401(k) plan at work and an individual retirement account (IRA) on your own. However, if either you or your spouse has a 401(k) plan, your traditional IRA contributions may not be tax-deductible. It depends on your tax filing status and income. For example, for married couples who file jointly, the income phase-out range is $126,000 to $146,000 if the spouse who is contributing to the IRA is covered by a workplace retirement plan, like a 401(k). (Roth IRA contributions are not tax-deductible.)

How Does Vesting Work in a 401(k) Plan?

Employee contributions to a 401(k) plan vest immediately, meaning that they belong to the employee from day one. Employer matching contributions can work differently, depending on the type of plan. With some types, such as safe harbor 401(k)s, matching contributions vest right away. With other types, such as traditional 401(k)s, employers can set different rules if they wish to. For example, the employer match might vest only after three years of service or vest gradually over a six-year period. If the employee parts ways with their employer before that period is up, they lose access to those matching contributions.

What Is Automatic Enrollment, and How Does It Work?

Automatic enrollment is a provision in some 401(k) plans that allows employers to defer a portion of an employee’s wages and deposit the money into a 401(k) account on their behalf. Employees can opt out if they wish to do so. Plans with this provision are sometimes referred to as automatic enrollment 401(k)s. Automatic enrollment (with an opt-out provision for those who don’t want to join) is mandatory for newly created 401(k) plans for plan years beginning after December 31, 2024.

Are 401(k) Plans Federally Insured?

No, unlike most bank and credit union accounts in the U.S., 401(k) plans are not covered by the Federal Deposit Insurance Corp. (FDIC).

In addition, the money you save in a 401(k) is invested. Investments are always subject to losses, and gains are never guaranteed.

The Bottom Line

There are several types of 401(k) plans that employers may offer their workers. Traditional and Roth plans are most common among larger employers, while SIMPLE and safe harbor plans are often found at small businesses. Business owners without other employees can also open one-participant 401(k) plans. If you have any questions about your plan, reach out to your employer or plan administrator.

Fact checked by Pete Rathburn
Reviewed by David Kindness

What Are Externalities?

An externality is a cost or benefit related to the production or consumption of a good or service that affects third parties unrelated to the production or consumption. It is generally the unintended, indirect consequence of everyday economic activities. 

Externalities occur when the transactions between two parties affect the existence and well-being of a third. In economics, there are four different types of externalities:

1. Positive consumption
2. Positive production
3. Negative consumption
4. Negative production

As implied by their names, externalities can have positive or negative effects.

Read on to learn how externalities affect equilibrium and market failure.

Key Takeaways

• An externality is a cost or benefit to an unrelated third party that stems from the production or consumption of a good or service.
• Equilibrium is the ideal balance between buyers’ benefits and producers’ costs
• Market failure is the inefficient distribution of goods and services in the market.
• Externalities lead to market failure because a product or service’s price equilibrium does not accurately reflect the true costs and benefits of that product or service.

Understanding Externalities

Externalities, which can be both positive or negative, can affect an individual or single entity, or they can affect society as a whole.

Those impacted by externalities—usually third parties—have no control over them and never choose to incur the costs or benefits.

It is primarily the responsibility of those generating externalities to account for them and manage them as much as possible.

Negative Externalities

Negative externalities usually come at a cost to individuals, while positive externalities generally provide a benefit.

For example, a crematorium releases toxic gases such as mercury and carbon dioxide into the air. This has a negative impact on people who may live in the area, causing them harm.

Pollution is another commonly known negative externality. Corporations and industries may try to curb their costs by using production measures that have a detrimental effect on the environment. While this may decrease the cost of production and increase revenues, it also imposes a cost on the environment and society.

Positive Externalities

Meanwhile, establishing more green spaces in a community brings more benefits to those living there.

Another positive externality is the investment in education. When education is easy to access and affordable, society benefits as a whole. People with an education can command higher wages, while employers have a labor pool that’s knowledgeable and trained.

Governments may choose to remove or reduce negative externalities through taxation and regulation. So, heavy polluters, for example, may be taxed and subject to more scrutiny.

Those who create positive externalities, on the other hand, may be rewarded with subsidies.

Important

Governments that regulate in an attempt to curb negative externalities must be prepared to monitor the producers and to hold those who fail to improve accountable.

Equilibrium and Market Failure

Externalities lead to market failure when a product or service’s price equilibrium does not accurately reflect the true costs and benefits of that product or service.

Equilibrium represents the ideal balance between buyers’ benefits and producers’ costs. It is supposed to result in the optimal level of production.

However, the equilibrium level is flawed when there are significant externalities, which create incentives that drive individual actors to make decisions which end up making the group worse off. This is known as a market failure.

When negative externalities are present, it means the producer does not bear all costs, which results in excess production.

With positive externalities, the buyer alone does not get all the benefits of the good; others benefit, too. This results in decreased production.

Negative Externality Example

Let’s look at a negative externality example of a factory that produces widgets. It pollutes the environment during the production process. The cost of the pollution is not borne by the factory, but is instead imposed upon and shared by society.

If the negative externality were taken into account, then the cost of the widget would be higher. This would result in decreased production and a more efficient price equilibrium.

In this case, though, the market failure was too much production and a price that didn’t match the true cost of production, as well as high levels of pollution.

Positive Externality Example

Now let’s take a a look at the relationship between positive externalities and market failure. Take education. Obviously, the person being educated benefits from and pays for this cost.

However, there are positive externalities beyond the one person being educated. These could be a more intelligent and knowledgeable citizenry, increased tax revenues from better-paying jobs, less crime, and more social stability.

All of these factors positively correlate with education levels. These benefits to society are not accounted for when the consumer considers the benefits of education.

Therefore, education would be under-consumed relative to its equilibrium price level if these benefits are taken into account.

Clearly, public policymakers should look to subsidize markets with positive externalities and punish those with negative externalities.

Note

Market failure occurs when the balance between supply and demand is upset and price equilibrium disappears. It reflects the inefficient allocation of resources.

Obstacles to Overcoming Externalities and Correcting Market Failure

One obstacle for policymakers in their efforts to correct market failures is the difficulty of quantifying externalities to increase or decrease consumption or production.

In the case of pollution, policymakers have tried tools, including mandates, incentives, penalties and taxes, that would result in increased costs of production for companies that pollute.

For education, policymakers have looked to increase consumption with subsidies, access to credit, and public education.

Moreover, in addition to positive and negative externalities, some other reasons for market failure include a lack of public goods, under-provision of goods, overly harsh penalties, and monopolies.

The upshot is that markets are the most efficient way to allocate resources, with the assumption that all costs and benefits are accounted for by prices.

When this is not the case, significant costs are inflicted upon society, as a result of underproduction or overproduction.

Can Markets Correct Externalities?

This is a topic of debate. They sometimes can, especially if the externality is small scale and the parties to the transaction can work out a fix. However, with major externalities, the government usually gets involved due to its ability to make the required impact.

When Do Externalities Happen?

They happen when the costs or benefits of an economic transaction between a producer and a consumer aren’t restricted just to them but indirectly affect other people.

What’s Government’s Role in Affecting Externalities?

A government can curb negative externalities by taking steps to tax the goods and services that are causing costs to affect uninvolved third parties. Conversely, it can support positive externalities by providing subsidies for the goods and services that affect third parties.

The Bottom Line

Being cognizant of externalities is one important step in combating market failure.

While price discovery and resource allocation mechanisms of markets need to be respected, market equilibrium is a balance between costs and benefits to the producer and consumer. It does not take third parties into account.

Thus, it is policymakers’ responsibility to adjust costs and benefits in an optimal way.

Reviewed by Margaret James
Fact checked by Jiwon Ma

What Is Impairment Loss?

Impairment loss occurs when a business asset suffers an unexpected, permanent depreciation in fair market value in excess of the book value of the asset on a company’s financial statements.

Assets can experience this decrease in value for a variety of reasons. These can include changes in market conditions, new government legislation, the enforcement of regulations, new technologies, and more.

Under U.S. generally accepted accounting principles, or GAAP, assets that are considered impaired must be recognized as a loss on an income statement.

Key Takeaways

• Impairment occurs when a business asset suffers a depreciation in fair market value in excess of the book value of the asset on a company’s financial statements.
• If the calculated costs of holding the asset exceed the calculated fair market value, the asset is considered to be impaired.
• Under GAAP, assets considered impaired must be recognized as a loss on an income statement.
• The technical definition of impairment loss is a decrease in net carrying value of an asset greater than the asset’s future undisclosed cash flow.

Understanding Impairment Loss

The technical definition of impairment loss is a decrease in net carrying value, the acquisition cost minus depreciation, of an asset that is greater than the future undisclosed cash flow of the same asset.

Impairment occurs when assets are sold or abandoned because the company no longer expects them to benefit long-run operations.

This is different from a write-down, though impairment losses often result in a tax deferral for the asset.

Depending on the type of asset impaired, stockholders of a publicly held company may also lose equity in their shares. This results in a lower debt-to-equity (D/E) ratio.

Important

Even when impairment results in a small tax benefit for the company, the realization of impairment is bad for the company as a whole. It usually represents the need for reinvestment.

Calculating Impairment Loss

1. The first step is to identify the factors that lead to an asset’s impairment. Some factors may include changes in market conditions, new legislation or regulatory enforcement, turnover in the workforce, or decreased asset functionality due to aging.

In some circumstances, the asset itself may be functioning as well as ever, but new technology or new techniques may cause the fair market value of the asset to drop significantly.

2. A fair market calculation is key; asset impairment cannot be recognized without a good approximation of fair market value. Fair market value is the price that the asset would fetch if it was sold on the market.

This is sometimes described as the future cash flow that the asset would expect to generate in continued business operations. Another term for this value is “recoverable amount.”

3. Once the fair market value is assigned, it is then compared with the carrying value of the asset as represented on the company’s financial statements.

Carrying value does not need to be recalculated at this time since it exists in previous accounting records.

4. If the calculated costs of holding the asset exceed the calculated fair market value, the asset is considered to be impaired.

If the asset in question is going to be disposed of, the costs associated with the disposal must be added back into the net of the future net value less the carrying value.

Impairment losses are either recognized through the cost model or the revaluation model, depending on whether the debited amount was changed through the new, adjusted fair market valuation described above.

What Does Impairment Mean?

In accounting, impairment refers to an unexpected and permanent drop in a fixed or intangible asset’s value to a market value that’s less than what’s recorded on a company’s balance sheet. The amount is recorded as a loss on the income statement.

How Does Impairment Loss Differ from a Write-Down?

A write-down leads to impairment loss. “Write-down” is an accounting term for the reduction in the book value of an asset when its fair market value (FMV) has fallen below the carrying book value, and thus becomes an impaired asset. Impairment loss often results in a tax deferral for the asset.

How Do I Start to Determine Impairment Loss?

Begin by identifying the factors that lead to an asset’s impairment. Factors may include:

• Changes in market conditions
• Decreased asset functionality due to aging
• New legislation or regulatory enforcement
• New technology or new techniques that may cause the asset’s fair market value to drop significantly
• Turnover in the workforce

The Bottom Line

Impairment occurs when a business asset suffers a permanent reduction in fair market value in excess of the book value of the asset on a company’s financial statements.

Under U.S. generally accepted accounting principles (GAAP), assets that are considered impaired must be recognized as a loss on an income statement.

Reviewed by David Kindness

In managerial accounting, the transfer price is the price at which a company’s subsidiary sells goods and services to another. Goods and services can include labor, components, parts used in production, and general consulting services.

Key Takeaways

• Transfer pricing is an accounting practice that records the price one company division charges another division for goods and services.
• Subsidiaries can sell labor, manufacturing parts, and other supplies to each other.
• Transfer prices impact three managerial accounting areas: division performance, managerial incentives, and taxes.

Transfer Price and Managerial Accounting

Transfer prices affect three managerial accounting areas:

• Transfer prices determine costs and revenues among transacting divisions, affecting the performance of each division.
• Transfer prices affect division managers’ incentives to sell goods either internally or externally. If the transfer price is too low, the upstream division may refuse to sell its goods to the downstream division, potentially impairing the company’s profit-maximizing goal.
• Transfer prices are especially important when products are sold across international borders. The transfer prices affect the company’s tax liabilities if different jurisdictions have different tax rates.

Important

Transfer pricing is regulated by Internal Revenue Service (IRS) Section 482, which advises that prices charged by one company affiliate to another, involving the transfer of goods, services, or intangibles, yield results that are consistent with the results that would have been realized if uncontrolled taxpayers make the same transaction.

Determining a Transfer Price

Transfer prices can be determined under the market-based, cost-based, or negotiated method. Under the market-based method, the transfer price is based on the observable market price for similar goods and services. Under the cost-based method, the transfer price is determined based on the production cost plus a markup if the upstream division wishes to earn a profit on internal sales.

Finally, upstream and downstream divisions’ managers can negotiate a transfer price that is mutually beneficial for each division. Transfer prices determine the transacting division’s costs and revenues.

If the transfer price is too low, the upstream division earns a smaller profit, while the downstream division receives goods or services at a lower cost. This affects the performance evaluation of the upstream and downstream divisions in opposite ways. For this reason, many upstream divisions price their goods and services as if they were selling them to an external customer at a market price.

Tax Liability

Transfer prices play a large role in determining the overall organization’s tax liabilities. If the downstream division is located in a jurisdiction with a higher tax rate compared to the upstream division, there is an incentive for the overall organization to make the transfer price as high as possible. This results in a lower overall tax bill for the entire organization.

When Does Transfer Pricing Lead Subsidiaries To Buy From Outside Sources?

If the upstream division manager has a choice of selling goods and services to outside customers and the transfer price is lower than the market price, the upstream division may refuse to fulfill internal orders and deal exclusively with outside parties.

How Does a High Transfer Price Affect Transactions Between Subsidiaries?

A high transfer price may provide the downstream division with the incentive to deal exclusively with external suppliers, and the downstream division may suffer from unused capacity.

How Does Transfer Pricing Affect Multinational Corporations?

The transfer pricing mechanism may help companies shift tax liabilities to low-cost tax jurisdictions. Multinational corporations (MNCs) are allowed to use the transfer pricing method to allocate earnings among their subsidiary and affiliates that are part

of the parent organization. The IRS and the Organization for Economic Cooperation and Development (OECD) oversee international taxable transactions.

The Bottom Line

The transfer price impacts the performance of both subsidiaries that transact with one another. A price that is too low disincentivizes an upstream division from selling to a downstream division, as it results in lower revenues. A price that is too high disincentives the downstream division from buying from the upstream division, as costs are too high. Arriving at a fair transfer price benefits both subsidiaries and allows for favorable tax setups.

Many of my female clients come to me feeling intimidated by investing. It’s understandable—our industry is often filled with men geeking out on complex topics like Sharpe ratios and technical analysis.

While it can seem like men are more financially savvy, research shows women are actually better investors than men. They are more likely to do their research and stick with the plan, less prone to overconfidence, and perform better on both the retail and professional money manager sides.

Here’s how I’m talking to my female clients about getting started on their investing journey with confidence.

Key Takeaways

• Studies show women outperform men by 1.8% annually due to traits like research, discipline, and less overconfidence.
• To build confidence, begin by understanding your current investments, defining asset allocation goals, and selecting appropriate funds with manageable fees.
• Avoid letting fear dictate your actions—set clear objectives and follow through with a consistent investment strategy.

What I’m Telling My Clients

The research shows women are great investors, but starting your investing journey can still feel scary. Here are some simple first steps:

1. Understand what you may already own. Do you have a retirement plan at work, an account you may have set up years ago, or something you own jointly with a spouse or partner? Find out the names of the investments inside those accounts and do a little research on what they are composed of. 
2. Develop a big-picture objective for the asset allocation you want to own. At the broadest level, that means the percentage of stocks vs. bonds.
3. Pick funds inside your accounts that get you to that allocation. While you’re at it, take a peek at the costs and fees of those funds. 
4. Once you have your plan in place, stick to it! Watch out for the temptation to fall prey to fear or think you can predict what the market will do next.

Note

According to a study from the Warwick School of Business, women investors outperformed men at investing by 1.8% each year.

The Bottom Line

Building confidence as a female investor starts with recognizing your own potential. Women have proven to be more disciplined and successful investors than many people realize. Although investing can feel intimidating, taking small, manageable steps—such as assessing your current assets, setting clear goals, and choosing the right funds—can help you begin your journey confidently.

Reviewed by Eric Estevez

You have to look at many different financial records to see if it’s a worthwhile risk when you’re considering investing in a company. What does it mean to you if you invest in a company after doing all your research and then it decides to borrow money?

You can evaluate whether the debt will affect your investment in a few ways.

Key Takeaways

• A company acquires debt when it issues securities.
• A company also acquires debt when it takes out loans from banks and other lending institutions.
• Look into how much debt the company has overall to determine the impact on an investment.
• Try to determine why the debt has been incurred.
• Compare the total to other company debt levels in the same industry.

How Does Corporate Debt Work?

A company can take on different types of debt. It can borrow money by two main methods:

• Issuing fixed-income (debt) securities like bonds, notes, bills, and corporate papers
• Taking out a loan from a bank or another lending institution

Fixed-Income Securities

Debt securities issued by the company are purchased by investors. You’re effectively lending money to a business or government when you buy any type of fixed-income security. The company must pay underwriting fees when issuing these securities but debt securities allow the company to raise more money and to borrow for longer durations than loans typically allow.

Loans

Borrowing from a private entity means going to a bank for a loan or a line of credit. Companies will commonly have open lines of credit from which they can draw to meet their cash requirements for day-to-day activities. The loan a company borrows from an institution can be used to pay the company payrolls, buy inventory and new equipment, or keep it as a safety net. Loans typically require repayment in a shorter period than most fixed-income securities.

What to Look for

An investor should consider a few things when deciding whether to continue their investment in a company that’s taking on new debt.

How Much Debt Does the Company Currently Have?

Taking on some debt if a company has absolutely no debt may be beneficial because it can give it more opportunity to reinvest resources into its operations. You might want to think twice, however, if the company in question already has a substantial amount of debt,

Too much debt is generally a bad thing for companies and shareholders because it inhibits a company’s ability to create a cash surplus.

Important

High debt levels can also negatively affect common stockholders who are last in line for claiming payback from a company that becomes insolvent.

What Kind of Debt Is the Company Taking on?

Loans and fixed-income securities that a company issues differ dramatically in their maturity dates. Some loans must be repaid within a few days of issue but others don’t have to be paid for several years. Debt securities issued to public investors will typically have longer maturities than the loans offered by private institutions and banks.

Large short-term loans may be harder for companies to repay but long-term fixed-income securities with high interest rates might not be easier on the company. Try to determine if the length and interest rate of the debt is suitable for financing the project that the company wants to undertake.

What Is the Debt for?

Is the debt meant to repay or refinance old debts or is it for new projects that have the potential to increase revenues?

You should typically think twice before purchasing stock in companies that have repeatedly refinanced their existing debt. This indicates an inability to meet financial obligations. A company that must consistently refinance may be doing so because it’s spending more than it’s making. Its expenses are exceeding its revenues. This is bad for investors.

One thing to note, however, is that it’s a good idea for companies to refinance their debt to lower their interest rates. This type of refinancing aims to reduce the debt burden but it shouldn’t affect the debt load and isn’t considered to be new debt.

Can the Company Afford the Debt?

Most companies will be sure of their ideas before committing money to them but not all companies succeed in making their ideas work. It’s important to determine whether the company can still make its payments if it gets into trouble or if its projects fail. Look into whether the company’s cash flows are sufficient to meet its debt obligations and make sure the company has diversified its prospects.

What Special Provisions May Force Immediate Payback?

Look to see whether any of its loan provisions might be detrimental to the company if the provision is enacted. Some banks require minimum financial ratio levels so the bank has the right to call or demand repayment of the loan if any of the company’s stated ratios drop below a predetermined level. Being forced to repay the loan unexpectedly can magnify any problem within the company and sometimes even force it into liquidation.

How Does the Company’s New Debt Compare to Its Industry?

Many different fundamental analysis ratios can help you along. These ratios are a good way to compare companies within the same industry:

• Quick Ratio (Acid Test): This tells investors approximately how capable the company is of paying off all its short-term debt without having to sell any inventory.
• Current Ratio: This ratio indicates the amount of a company’s short-term assets versus its short-term liabilities. The greater the short-term assets compared to liabilities, the better off the company is in paying off its short-term debts.
• Debt-To-Equity Ratio: This measures a company’s financial leverage that’s calculated by dividing long-term debt by shareholders’ equity. It indicates what proportions of equity and debt the company is using to finance its assets.

What Are Equity Securities?

Common stock is an equity security. Each share awards partial ownership in the company when it’s sold to an investor. The percentage of ownership depends on the percentage of total shares issued.

What’s the Difference Between Common and Preferred Stock?

Common stock provides an investor with ownership rights. A share typically represents one vote on important issues affecting the company. The shares may increase in value as the company earns a profit.

Preferred stock generally may not provide voting rights but it often pays dividends that are more significant than the returns provided by common stock shares. Price per share doesn’t generally increase, however. Preferred shareholders are generally first in line for payout if the company fails and liquidates, ahead of common shareholders.

How Can I Look Into a Company’s Cash Flows?

The information you need will be available on the company’s cash flow statements. They’re typically issued for each accounting period and they segregate cash flow into operating, investing, and financing activities. These statements are available in the company’s Form 10-K and Form 10-Q filings.

The Bottom Line

A company that’s increasing its debt load should have a plan for repaying it. Try to ensure that the company knows how the debt affects investors, how the debt will be repaid, and how long it will take to do so when you have to evaluate a company’s debt.