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What is a 'Debt Instrument'

A debt instrument is a paper or electronic obligation that enables the issuing party to raise funds by promising to repay a lender in accordance with terms of a contract. Types of debt instruments include notes, bonds, debentures, certificates, mortgages, leases or other agreements between a lender and a borrower. These instruments provide a way for market participants to easily transfer the ownership of debt obligations from one party to another.

A debt instrument is legally enforceable evidence of a financial debt and the promise of timely repayment of the principal, plus any interest. The importance of a debt instrument is twofold. First, it makes the repayment of debt legally enforceable. Second, it increases the transferability of the obligation, giving it increased liquidity and giving creditors a means of trading these obligations on the market. Without debt instruments acting as a means of facilitating trading, debt would only be an obligation from one party to another. However, when a debt instrument is used as a trading means, debt obligations can be moved from one party to another quickly and efficiently.

Debt instruments can be either long-term obligations or short-term obligations. Short-term debt instruments, both personal and corporate, come in the form of obligations expected to be repaid within one calendar year. Long-term debt instruments are obligations due in one year or more, normally repaid through periodic installment payments.

Short-Term Debt Instruments

From a personal finance perspective, short-term debt instruments come in the form of credit card bills, payday loans, car title loans and other consumer loans that have repayment terms of less than 12 months. If a person incurs a credit card bill of $1,000, the debt instrument is the agreement that outlines the obligated payment terms between the borrower and the lender.

In corporate finance, short-term debt usually comes in the form of revolving lines of credit, loans that cover networking capital needs and Treasury bills. If for example, a corporation looks to cover six months of rent with a loan while it tries to raise venture funding, the loan is considered a short-term debt instrument.

Long-Term Debt Instruments

Long-term debt instruments in personal finance are usually mortgage payments or car loans. For example, if an individual consumer takes out a 30-year mortgage for $500,000, the mortgage agreement between the borrower and the mortgage bank is the long-term debt instrument.

 

 However, sometimes, long-term debt instruments, like car loans become short-term instruments when the obligation is expected to be fully repaid within one year. If a person takes out a five-year car loan, after the fourth year, the debt becomes a short-term instrument.

For corporations, long-term debt instruments come in the form of corporate debt. This type of debt is used to fund growth and expansion and is classified on a company's balance sheet.

BREAKING DOWN 'Debt Instrument'

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