Overextension

What Is Overextension?

The term "overextension" refers to a situation in finance in which an individual or corporation has more debt than they can handle and repay. Consumers who must use more than a third of their net income to repay debt are generally considered to be overextended. They may need to consolidate their debts into a single loan. Granting more credit to overextended consumers or companies can be a great risk to lenders. Being overextended also represents excessive leverage in a trader or investor's account equity and their buying power for securities.

Understanding Overextension

Being overextended can mean several different things in finance. As noted above, it is most commonly used to describe an individual or company's financial situation when they have more debt than they can afford to repay. Entities that use at least one-third of the money they make to repay debt are considered overextended. For instance, someone who makes $30,000 a year and pays $10,000 to satisfy their debt load is overextended. The same principle applies to companies that have more debt than earned income.

Credit, debt, and overextension are tricky to model financially. Because they can have a snowball effect, where conditions pile onto one another, conventional linear models do not account for the nonlinear, exponential nature of credit risk. Often, once strong credit issuers or borrowers can rapidly deteriorate to weak credits as Murphy's law works against an individual or business—anything that can go wrong will go wrong.

In many cases, consumers may have to turn to additional debt to take control of their finances. This often comes through debt consolidation, which involves paying off individual debts by taking on a larger loan. Doing so ensures that the borrower only has one large payment to make rather than many smaller ones. However, companies may have to find new ways to raise capital, such as issuing new shares of equity rather than taking on more debt.

As mentioned earlier, overextension is also used to describe excess leverage in trader and investors' account equity and buying power. Overextension of this kind can greatly amplify losses in a bear market and force the trader to meet steep margin calls. The inability to do this can result in forced liquidation of securities and the freezing of the account.

Special Considerations

The idea of overextension varies based on the financial characteristics of a borrower. Wealthy individuals and cash-rich businesses can take on proportionally more debt than weaker borrowers without overextending themselves.

Becoming overextended can be out of the control of a firm's management. For example, during a steep economic downturn, such as a recession, a company's financial condition can materially deteriorate largely out of the company's control. During tough economic times, it is not uncommon for a once healthy business to become overextended as conditions move out of its favor.

This can happen to entire sectors even during robust economic climates. For instance, traditional brick-and-mortar retailers have struggled to adjust to online and e-commerce competition, despite record growth in many segments of the economy.