What Is Borrowed Capital?
Borrowed capital consists of money that is borrowed and used to make an investment. It differs from equity capital, which is owned by the company and shareholders. Borrowed capital is also referred to as "loan capital" and can be used to grow profits but it can also result in a loss of the lender's money.
- Borrowed capital is money that is borrowed from others, either individuals or banks, to make an investment.
- Equity capital is owned by the company and shareholders and is the opposite of borrowed capital.
- Borrowed capital can take the form of loans, credit cards, overdraft agreements, and the issuance of debt, such as bonds.
- The interest rate is always the cost of borrowed capital.
- Increased profits can be obtained through the use of borrowed capital but it can also result in the loss of the lender's money.
Understanding Borrowed Capital
Businesses need capital to operate. Capital is wealth that is used to generate more wealth. For businesses, capital consists of assets—property, factories, inventories, cash, etc. Businesses have two options to acquire these: debt financing and equity financing. Debt is money that is borrowed from financial institutions, individuals, or the bond market. Equity is money the company already has in its coffers or can raise from would-be owners or investors. The term "borrowed capital" is used to distinguish capital acquired with debt from capital acquired with equity.
There are many different borrowing methods that constitute borrowed capital. These can take the form of loans, credit cards, overdraft agreements, and the issuance of debt, such as bonds. In all instances, a borrower must pay an interest rate as the cost of borrowing. Typically, debt is secured by collateral. In the case of a home purchase, the mortgage is secured by the house being acquired. Borrowed capital may also take the form of a debenture, however, and in that case, it is not secured by an asset.
Borrowed capital is commonly used in the economy whether that be for personal reasons or for business reasons. According to a Congressional Research Service report from 2019, almost 80% of small businesses in the U.S. relied on borrowed capital to operate their businesses. In 2018, small business loans amounted to $632.5 billion.
The upside of investing with borrowed capital is the potential for greater gains. The downside is the potential for greater losses, given that the borrowed money must be paid back somehow, regardless of the investment's performance.
Example of Borrowed Capital
To use an example from personal finance, when a person buys a home they typically make a down payment. The down payment comes out of their own wealth; their savings or proceeds from the sale of another house. If a home costs $300,000, their down payment would be $60,000, which is a 20% down payment; standard in the United States. The remaining cost of the house, $240,000 ($300,000-$60,000), would need to be borrowed.
The additional funds needed to purchase the house would come in the form of a mortgage loan from a bank. So, the house, which is now an asset belonging to the homeowner, is acquired with both equity and debt, or borrowed capital, in the form of a mortgage. The cost to borrow the $240,000 would come with a monthly interest rate that the homeowner would need to pay in addition to the principal installments of paying back the loan.