Next video:
Loading the player...

Debt is any amount a borrower owes a lender. From an economic standpoint, the money a borrower receives in a loan is really an advance on future earnings.  The debt represents an obligation to use a portion of future periodic earnings to pay back the debt over time. 

Debt comes in many forms.  For individuals, it is usually in the form of credit card balances, a home mortgage, car loans, and personal lines of credit.  Businesses and corporations have more options, including trade payables, bonds and commercial paper.

On the lender’s side of the debt transaction, the borrower pays the lender interest as compensation for the lender’s potential risk of not being paid back the amount that was loaned. The interest rate is based on the lender’s assessment of risk - the riskier the loan, the higher the interest rate.

Debt allows a borrower to make high-value purchases without having the entire amount of cash on hand to make the purchase.  Most homeowners would not have been able to purchase their home without borrowing the money and then using a portion of their income to make monthly mortgage payments.

Corporations also finance their high dollar purchases with debt, often for the same reason – they lack the necessary funds.  The smart use of debt can make a business more profitable, for example, using the borrowed funds to buy equipment for systems that increase the profitability of the business. This form of value enhancement is known as leveraging debt.

Related Articles
  1. Investing

    Explaining Debt Service

    Debt service is a measure of a person or entity’s use of cash to pay interest and principal on debt obligations.
  2. Investing

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  3. Retirement

    When Are Mortgage Lenders Better Than Banks?

    Individuals seeking a mortgage loan should consider factors or circumstances that may make a mortgage lender a better choice than a traditional bank.
  4. Personal Finance

    Personal Loans: Consider These Alternative Lenders

    Looking for an alternative source of financing for a personal loan? Take a look at these companies.
  5. Personal Finance

    Best 5 Money-Saving Tips to Get out of Debt

    Understand the different types of debt and the reasons why people get into debt. Learn about five tips to follow to get out of debt.
  6. Investing

    What are Debt Instruments?

    A debt instrument is a documented financial obligation that enables the issuer to raise funds by borrowing money and repaying it in the future.
  7. Investing

    What are the Five C's of Credit?

    The five C’s of credit are what banks and other lenders evaluate about a potential borrower when making a lending decision. The five C’s are Character, Capacity, Capital, Collateral and Conditions. ...
  8. Personal Finance

    Purchasing a Home with Bad Credit Is Possible: Here's How

    A bad credit report can become an obstacle, resulting in denials for credit or higher interest rates, but borrowers with low credit scores can still purchase a home.
  9. Investing

    Financing Basics For First-time Homebuyers

    If you're looking to get your first mortgage, there are many financing options available.
Hot Definitions
  1. Book Value

    1. The value at which an asset is carried on a balance sheet. To calculate, take the cost of an asset minus the accumulated ...
  2. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends each year relative to its share price.
  3. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. ...
  4. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  5. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  6. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
Trading Center