What Is Debt?
Debt is something, usually money, borrowed by one party from another. Debt is used by many corporations and individuals to make large purchases that they could not afford under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.
- Debt is money borrowed by one party from another.
- Many corporations and individuals use debt as a method of making large purchases that they could not afford under normal circumstances.
- In a debt-based financial arrangement, the borrowing party gets permission to borrow money under the condition that it must be paid back at a later date, usually with interest.
- Debt can be classified into four main categories: secured, unsecured, revolving, or mortgaged.
- Corporations issue debt in the form of bonds to raise capital.
The most common forms of debt are loans, including mortgages, auto loans, personal loans, and credit card debt. Under the terms of a loan, the borrower is required to repay the balance of the loan by a certain date, typically several years in the future. The terms of the loan also stipulate the amount of interest that the borrower is required to pay annually, expressed as a percentage of the loan amount. Interest is used to ensure that the lender is compensated for taking on the risk of the loan while also encouraging the borrower to repay the loan quickly to limit his total interest expense.
Credit card debt operates in the same way as a loan, except that the borrowed amount changes over time according to the borrower's need—up to a predetermined limit—and has a rolling, or open-ended, repayment date. Certain types of loans, including student loans and personal loans, can be consolidated.
Types of Debt
There are four main categories of debt. Most debt can be classified as either secured debt, unsecured debt, revolving debt, or a mortgage.
Secured debt is collateralized debt. Debtees usually require the collateral to be property or assets with a large enough value to cover the amount of the debt. Examples of collateral include vehicles, houses, boats, securities, and investments. These items are pledged as security and the agreement is created with a lien. Upon default, the collateral may be sold or liquidated, with the proceeds used to repay the loan.
Like most classes of debt, secured debt often requires a vetting process to verify the creditworthiness of the borrower and their ability to pay. In addition to the standard review of income and employment status, the ability to pay may include verifying the collateral and assessing its value.
Unsecured debt is debt that does not require collateral as security. The creditworthiness and the debtor's ability to repay are reviewed before consideration is given. Since no collateral assignment is issued, the debtor's credit profile is the primary factor used in determining whether to approve or deny lending.
Examples of unsecured debt include unsecured credit cards, automobile loans, and student loans. How much is loaned is often based on the debtor's financial position, including how much they earn, how much liquid cash is available, and their employment status.
Revolving debt is a line of credit or an amount that a borrower can continuously borrow from. In other words, the borrower may use funds up to a certain amount, pay it back, and borrow up to that amount again.
The most common form of revolving debt is credit card debt. The card issuer initiates the agreement by offering a line of credit to the borrower. As long as the borrower fulfills their obligations, the line of credit is available for as long as the account is active. With a favorable repayment history, the amount of revolving debt may increase.
A mortgage is a debt issued to purchase real estate, such as a house or condo. It is a form of secured debt as the subject real estate is used as collateral against the loan. However, mortgages are so unique that they deserve their own debt classification.
There are different types of mortgage loans, including Federal Housing Administration (FHA), conventional, rural development, and adjustable-rate mortgages (ARMs), to name a few. In general, lenders use a baseline credit score for approval, and those minimum requirements may vary according to the type of mortgage.
Mortgages are most likely the largest debt, apart from student loans, that consumers will ever owe. Mortgages are usually amortized over long periods, such as 15 or 30 years.
In addition to loans and credit card debt, companies that need to borrow funds have other debt options. Bonds and commercial paper are common types of corporate debt that are not available to individuals.
Commercial paper is short-term corporate debt with a maturity of 270 days or less.
Bonds are a type of debt instrument that allows a company to generate funds by selling the promise of repayment to investors. Both individuals and institutional investment firms can purchase bonds, which typically carry a set interest, or coupon, rate. If a company needs to raise $1 million to fund the purchase of new equipment, for example, it can issue 1,000 bonds with a face value of $1,000 each.
Bondholders are promised repayment of the face value of the bond at a certain date in the future, called the maturity date, in addition to the promise of regular interest payments throughout the intervening years. Bonds work just like loans, except the company is the borrower, and the investors are the lenders, or creditors.
Advantages and Disadvantages of Debt
In corporate finance, there is a lot of attention paid to the amount of debt a company has. A company that has a large amount of debt may not be able to make its interest payments if sales drop, putting the business in danger of bankruptcy. Conversely, a company that uses no debt may be missing out on important expansion opportunities.
Securing debt from a financial institution allows companies access to the capital needed to perform certain tasks or complete projects. Contrary to stockholders' involvement in the management of a company, the financier of debt has no involvement in how the company is managed. Also, the interest expense is tax-deductible. For consumers, interest expenses are deductible for mortgages but not for regular consumer debt.
Different industries use debt differently, so the "right" amount of debt varies from business to business. When assessing the financial standing of a given company, various metrics are used to determine if the level of debt, or leverage, the company uses to fund operations is within a healthy range.
When collateral secures a debt, that collateral may be subject to confiscation if the borrower defaults on the agreement. Even when adhering to the terms, consumers and businesses with too much debt may be considered too risky to be approved for new debt, limiting access to additional funds to fulfill other obligations and duties.
Injects capital to fund projects
Reduces tax obligations
Increases access to new opportunities
Increases risk of insolvency
Compromises collateralized property
Restricts access to new debt when the borrower has too much
What Are Examples of Debt?
Debt is anything owed by one party to another. Examples of debt include amounts owed on credit cards, car loans, and mortgages.
What Is the Legal Definition of Debt?
According to 15 U.S. Code Section 1692a, debt is defined as "any obligation or alleged obligation of a consumer to pay money arising out of a transaction in which the money, property, insurance, or services which are the subject of the transaction are primarily for personal, family, or household purposes, whether or not such obligation has been reduced to judgment."
How Can I Get Out of Debt Fast?
How soon you can get out of debt depends on how much debt you have and how much more you can pay to reduce it. Create a plan, set a budget, and do not acquire more debt. Consider restricting nonessential spending and use what you save to pay down your debt.
Often, creditors require you to only pay a minimum amount. Pay more than the minimum to quickly reduce what you owe. Debt consolidation is also an option that can help you restructure your debt into more manageable terms, helping you get out of debt faster.
What Is Debt Consolidation?
Debt consolidation involves acquiring new debt to pay off multiple, existing debts. The new loan becomes the single source of debt, which usually results in a lower overall payment, a reduced interest rate, and a new repayment schedule.
What Is the Difference Between Debt and a Loan?
Debt and loan are used synonymously, but there are slight differences. Debt is anything owed by one person to another. Debt can involve real property, money, services, or other consideration. In finance, debt is more narrowly defined as money raised through the issuance of bonds.
A loan is a form of debt but, more specifically, is an agreement in which one party lends money to another. The lender sets repayment terms, including how much is to be repaid and when. They also may establish that the loan must be repaid with interest.
The Bottom Line
Debt is something, usually money, owed by one party to another. Most debts—such as credit cards, home loans, and auto loans—are categorized as secured, unsecured, revolving, or mortgaged. Corporations often have varying types of debt, including corporate debt. Corporate debt involves the issuance of bonds to investors to generate capital, often for projects. Debt can be used to fund needed projects, fulfill the dream of homeownership, or pay for higher education. However, too much or uncontrolled debt can harm borrowers as it limits their potential to repay.