Debt: Meaning & Definition
Have you ever borrowed money from someone? It could have been from a friend, a family member, or from a bank. Yet, any time money is borrowed by one person from another, debt gets created. Taking on debt can either be a good thing or it can sometimes negatively affect you financially.
But how do you know if debt will help you or not? There can be a lot to consider. That’s why we put together this guide to break down everything you need to know about debt. Keep reading to learn how it works, the different types, and what debt should be avoided.
Table of Contents
KEY TAKEAWAYS
- Debt is something that’s borrowed by a party from another part, and it’s usually money.
- Individuals and corporations often use debt to help mark large purchases that they wouldn’t be able to afford in normal, regular circumstances.
- There are four main categories used to classify debt, they are secured, unsecured, revolving, or mortgaged.
- With debt-based financial agreements, there’s a condition that the borrowing party that borrows the money must pay the debt back at a future date.
- Corporations often use bonds when they issue debt to help raise additional capital.
What Is Debt?
Debt is something that one party borrows from another party, and it’s usually money. Many individuals and corporations use debt markets to help purchase certain things that they might not otherwise be able to afford.
With a debt agreement, a borrowing party is permitted to borrow money from someone such as a lender. The agreement will also outline that the debt must be paid back at a time in the future and will often include accumulated interest.
How Does Debt Work?
There can be several different types of debt, and some of the most common include credit card debt, personal loans, mortgages, and auto loans. In the agreement of the loan, the borrower is going to be required to pay back the balance of the overall loan, or the debt cost. This is usually at a future date and can be years in the future.
The terms of the loan are also going to outline how much interest the borrower will need to pay on an annual basis. This is typically expressed as a percentage of the total loan amount. Interest is charged by the lender to ensure that they’re able to be compensated for the risks that come with issuing a loan.
As well, borrowers are encouraged to repay the loan as quickly as possible to reduce the total amount of interest they have to pay. Having credit card debt works similarly. However, the amount of debt can change over a period of time depending on specific needs, such as informal debts or non-housing debt.
Credit card debt is up to a predetermined limit and it will have an open-ended or rolling repayment date. As well, other types of loans such as personal loans or student loans can be consolidated with the likes of credit card debt.
Types of Debt
There are several different types of formal debt that an individual or business can take on, such as informal loans or a principle loan for example. However, there are five primary categories that all debt can be put into. In this case, they’re classified as secured debt, unsecured debt, revolving debt, mortgage debt, and corporate debt.
Here is a breakdown of the five main categories of debt and some of their most common types.
Secured Debt
Having secured debt means that it’s collateralized debt, which is when collateral is required to cover the total amount of the debt. Usually, collateral can consist of assets or property, such as investments, debt securities, vehicles, boats, and houses.
When you take out a secured debt, you will have to pledge collateral as security which is then turned into a lien that’s outlined in the agreement. If for some reason you end up defaulting on the debt, the collateral can then get liquidated or sold to help repay the cost of the loan.
Most types of debt are going to require some type of vetting process to ensure creditworthiness. This helps lenders find out if you’re going to have the ability to repay the loan when required. The vetting process can include verifying the collateral offering and assessing its value, as well as a standard review of income and employment status.
Unsecured Debt
Opposite secured debt, unsecured debt doesn’t require any collateral as a security precaution against default. However, the overall creditworthiness and your ability to repay the debt will still get considered when it comes to debt cancellation.
This vetting process is essentially going to be the only factor that’s used in determining if you will be approved or denied for lending. Some of the most common examples of unsecured debt include student loans, automobile loans, and credit cards.
The unsecured debt amount you could receive is also going to depend on a few different factors. These can include your employment status, how much liquid cash you have available, how much you earn, and your overall financial position.
Revolving Debt
Revolving debt is an amount of debt you’re able to borrow and keep being able to borrow from, such as a line of credit. You have the option to use the funds up to a specified amount. Once you pay it back, you can then borrow up to the same amount again.
In this case, credit card debt is the most common type of revolving debt. Essentially, the card issuer will create an agreement that offers you a line of credit. As long as you pay back the amount and fulfill the outlined obligations, it will be available for as long as you keep the account active.
Mortgage Debt
Mortgage debt is used to purchase various types of real estate, such as a condo or a house. In essence, a mortgage is a secured debt since the real estate that is purchased is then able to be used as collateral. But since there are so many different types of mortgage loans and nuances that go into them, it often has its own debt classification.
There can be different types of mortgage lending and each could come with a different lending capacity. For example, it could be a conventional loan, a rural development loan, a Federal Housing Administration (FHA) loan, or an adjustable-rate mortgage. The cost of mortgage payments will depend on things such as monthly income, repayment history, and the bank lenders that issue it.
There will often be a credit score that needs to be met for lenders to approve a mortgage, but the level could vary depending on the type. Taking out a mortgage will often include it being amortized over a long period, which can range anywhere from 15 to 30 years.
Corporate Debt
Apart from an individual, corporations and business owners will often need to use debt for financing. For example, commercial paper and the issuance of bonds are specific types of corporate debt that individuals won’t have access to.
Bonds are a debt instrument that provides a business with the opportunity to generate additional funds. By doing this, it basically promises to repay investors for the money received so there isn’t income loss. This can help with general business activity and bonds can be good business investments compared to the cost of debt relief.
Essentially, any bondholders will receive a repayment of the face value of the bond financing in the future. This is known as the maturity date and it’s in addition to interest payments that get paid regularly. Bond markets work in the exact same way as an individual loan, except in this case the business becomes the borrower and the creditors or lenders are the investors.
Sometimes, commercial loans will be part of a syndicated loan, which is where multiple lenders or investors have a share of debt relief. This is also known as loan syndication and can be common with long-term bonds. Investment banks and commercial banks are common financial institutions.
Advantages and Disadvantages of Debt
There can be both advantages and disadvantages to various types of debt and what they’re needed for. In corporate finance, the amount of debt a company has is an important financial metric to consider.
If a company has a large amount of debt and sales start to drop, it could have a difficult time repaying for making interest payments. Ultimately, this can put the business at risk of bankruptcy.
However, the opportunity to secure debt will allow a business to gain access to capital for certain projects or tasks. It’s also worth noting that in the case of corporate finance, interest expenses are tax-deductible. For individual consumers, the only interest expenses that are tax-deductible are for mortgages, not for other consumer debt types.
Here are the primary advantages and disadvantages of debt.
Advantages
- It allows the opportunity to reduce certain tax obligations
- It can increase access to opportunities
- It can allow access to new capital to help fund new projects or expansions
Disadvantages
- It can put collateral at risk, such as property
- It can limit the ability to access new debt
- It can increase the overall possibility and risk of insolvency or bankruptcy
What Types of Debt Should be Avoided?
A lifestyle of debt should be avoided when you can. Carrying an excess of debt will come with its set of risks, but making payments on time and keeping your debt level balanced will ensure you stay ahead of financial obligations. As well, you will avoid debt collectors and debt consolidation by making your repayment periods and repayment target.
That said, types of debt to avoid are credit card debt, medical debt, and car loan debt. Having good payment transparency can help you with your ratio of debt or the proportion of debt. This way, your payment mechanisms will be more efficient. And if you operate a business, keeping the relationship between debt and profits well-balanced will help avoid business failure.
Summary
Debt is something that’s borrowed by one party from another, usually money, and is expected to be repaid with interest. Some of the most common kinds of debt include home loans such as mortgages, automobile loans, student loans, and credit cards.
There are five primary categories that most debt will fall into. These are secured, unsecured, revolving, mortgage, and corporate. Corporate debt includes issuing bonds to receive extra capital to help fund new projects. Carrying debt from time to time can always come with risks, but managing repayments efficiently will help with debt relief.
Frequently Asked Questions on Debt
Debt for a company can mean issuing bonds to investors to help raise capital. The debt issuer will provide the financing to the company, and the company will have to pay interest on the amount that’s borrowed.
Essentially, a loan is a type of debt. Personal debt is anything that’s owed by one individual to another, such as money, property, or services. A loan is an agreement where one party decides to lend money to another party.
There are several different types of debt, but one of the most common is a mortgage. It’s often the largest type of debt that a consumer will carry and mortgages are taken out to purchase real estate, such as a home.
Share: