In the event a bond issuer can not meet scheduled payments, there is risk of defaulting on those obligations. Annual debt service should reduce those risks because it is the practice of earmarking cash for debt payments associated with new and existing bond issuance each year. These obligations include interest and principal payments to investors as agreed upon at the onset of an investment. Debt service can be performed by any bond issuer, including corporations, governments, and municipalities. An individual can perform annual debt service by budgeting in monthly house payments each year.
Some entities turn to the debt capital markets to issue bonds as opposed to the equity markets to issue stocks because of the discipline that is tied to having debt. Issuers have an obligation to creditors to make consistent interest payments until maturity, or when a bond expires. At that point, the face value of the debt instrument must be repaid. Annual debt service is required for budgeting purposes so that investors are paid as expected. The consequences otherwise could lead to default. In the event of a bankruptcy, debt holders have seniority to be repaid.
Before a public issuer, such as a municipality, can turn to the debt markets to issue bonds, there likely needs to be support from regional legislatures. Upon approval, a town can issue bonds to the public in an attempt to raise money for projects, such as infrastructure enhancements. As part of the annual debt service, that municipality outlines the expected cash payments that must be directed towards interest and principal payments to bondholders for given projects throughout the year.
Poor planning surrounding the servicing of this debt could lead to the need to transfer funds originally meant for a different purpose to instead fulfill bond obligations. If a municipality foresees rising debt service obligations, it may need to make cuts or raise prices for public services, such as transportation, in order to meet those payments. In some cases, the debt service status could be so tenuous that employees may lose jobs or be asked to retire early.
For the individual, household annual debt service can be expressed as a ratio. It is a calculation using debt obligations, including interest and principal on mortgages and consumer debt, and expressed as a percentage of net income. The higher the percentage, the greater amount of an individual's household income is being directed towards annual debt service.
