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Debt is an obligation that requires one party, the
debtor
A debtor or debitor is a legal entity (legal person) that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterpart of this ...
, to pay
money
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
or other agreed-upon value to another party, the
creditor
A creditor or lender is a party (e.g., person, organization, company, or government) that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property ...
. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The debt may be owed by
sovereign state
A sovereign state or sovereign country, is a polity, political entity represented by one central government that has supreme legitimate authority over territory. International law defines sovereign states as having a permanent population, defin ...
or country,
local government
Local government is a generic term for the lowest tiers of public administration within a particular sovereign state. This particular usage of the word government refers specifically to a level of administration that is both geographically-loca ...
,
company
A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal person, legal or a mixture of both, with a specific objective. Company members share a common p ...
, or an individual. Commercial debt is generally subject to
contractual term
A contractual term is "any provision forming part of a contract". Each term gives rise to a contractual obligation, the breach of which may give rise to litigation. Not all terms are stated expressly and some terms carry less legal gravity as th ...
s regarding the amount and timing of repayments of
principal and
interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct ...
.
Loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that d ...
s,
bonds, notes, and
mortgages
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pu ...
are all types of debt. In
financial accounting
Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, s ...
, debt is a type of
financial transaction
A financial transaction is an agreement, or communication, between a buyer and seller to exchange goods, services, or assets for payment. Any transaction involves a change in the status of the finances of two or more businesses or individuals. A ...
, as distinct from
equity
Equity may refer to:
Finance, accounting and ownership
* Equity (finance), ownership of assets that have liabilities attached to them
** Stock, equity based on original contributions of cash or other value to a business
** Home equity, the dif ...
.
The term can also be used metaphorically to cover
moral
A moral (from Latin ''morālis'') is a message that is conveyed or a lesson to be learned from a story or event. The moral may be left to the hearer, reader, or viewer to determine for themselves, or may be explicitly encapsulated in a maxim. A ...
obligations and other interactions not based on a monetary value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.
Etymology
The English term "debt" was first used in the late 13th century.
The term "debt" comes from "dette, from
Old French
Old French (, , ; Modern French: ) was the language spoken in most of the northern half of France from approximately the 8th to the 14th centuries. Rather than a unified language, Old French was a linkage of Romance dialects, mutually intelligib ...
dete, from Latin debitum "thing owed," neuter past participle of debere "to owe," originally, "keep something away from someone," from de- "away" (see de-) + habere "to have" (see habit (n.)). Restored spelling
as used
As, AS, A. S., A/S or similar may refer to:
Art, entertainment, and media
* A. S. Byatt (born 1936), English critic, novelist, poet and short story writer
* "As" (song), by Stevie Wonder
* , a Spanish sports newspaper
* , an academic male voice ...
after c. 1400.
The related term "debtor" was first used in English also in the early 13th century; the terms "dettur, dettour,
ame #REDIRECT AME
{{redirect category shell, {{R from other capitalisation{{R from ambiguous page ...
from Old French detour, from Latin debitor "a debter," from past participle stem of debere;...The -b- was restored in later French, and in English c. 1560-c. 1660." In the
King James Bible
The King James Version (KJV), also the King James Bible (KJB) and the Authorized Version, is an Bible translations into English, English translation of the Christian Bible for the Church of England, which was commissioned in 1604 and publis ...
, only one spelling, "debtor", is used.
Principal
Principal is the amount of money originally invested or loaned, on which basis interest and returns are calculated.
Repayment
There are three main ways repayment may be structured: the entire principal balance may be due at the maturity of the loan; the entire principal balance may be
amortized
In computer science, amortized analysis is a method for analyzing a given algorithm's complexity, or how much of a resource, especially time or memory, it takes to execute. The motivation for amortized analysis is that looking at the worst-case ...
over the term of the loan; or the loan may be partially amortized during its term, with the remaining principal due as a "
balloon payment
A balloon payment mortgage is a mortgage which does not fully amortize over the term of the note, thus leaving a balance due at maturity.Wiedemer, John P, ''Real Estate Finance, 8th Edition'', p 109-110 The final payment is called a ''balloon ...
" at maturity. Amortization structures are common in
mortgage
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pu ...
s and
credit card
A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the card issuer to pay them for the amounts plus the o ...
s.
Default provisions
Debtors of every type
default on their debt from time to time, with various consequences depending on the terms of the debt and the law governing default in the relevant jurisdiction.
If the debt was secured by specific
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
, such as a car or home, the creditor may seek to repossess the collateral. In more serious circumstances, individuals and companies may go into
bankruptcy
Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor ...
.
Types of giving finance
Individuals
Common types of debt owed by individuals and households include
mortgage loan
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any p ...
s, car loans,
credit card
A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the card issuer to pay them for the amounts plus the o ...
debt, and
income tax
An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called taxable income). Income tax generally is computed as the product of a tax rate times the taxable income. Tax ...
es. For individuals, debt is a means of using anticipated
income
Income is the consumption and saving opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms. Income is difficult to define conceptually and the definition may be different across fields. For ...
and future
purchasing power
Purchasing power is the amount of goods and services that can be purchased with a unit of currency. For example, if one had taken one unit of currency to a store in the 1950s, it would have been possible to buy a greater number of items than would ...
in the present before it has actually been earned. Commonly, people in industrialized nations use consumer debt to purchase houses, cars and other things too expensive to buy with cash on hand.
People are more likely to spend more and get into debt when they use credit cards vs. cash for buying products and services.
[Prelec, D. & Loewenstein, G. (1998). The red and the black: Mental accounting of savings and debt. Marketing Science, 17(1), 4-28.][Raghubir, P. & Srivastava, J. (2008)]
Monopoly money: The effect of payment coupling and form on spending behavior
. Journal of Experimental Psychology: Applied, 14 (3), 213–25. This is primarily because of the transparency effect and consumer's "pain of paying."
[Soman, D. (2003)]
The effect of payment transparency on consumption: Quasi experiments from the field
Marketing Letters, 14, 173–183. The transparency effect refers to the fact that the further you are from cash (as in a credit card or another form of payment), the less transparent it is and the less you remember how much you spent.
The less transparent or further away from cash, the form of payment employed is, the less an individual feels the “pain of paying” and thus is likely to spend more.
Furthermore, the differing physical appearance/form that credit cards have from cash may cause them to be viewed as
“monopoly” money vs. real money, luring individuals to spend more money than they would if they only had cash available.
Besides these more formal debts, private individuals also lend informally to other people, mostly relatives or friends. One reason for such informal debts is that many people, in particular those who are poor, have no access to affordable credit. Such debts can cause problems when they are not paid back according to expectations of the lending household. In 2011, 8 percent of people in the
European Union
The European Union (EU) is a supranational political and economic union of member states that are located primarily in Europe. The union has a total area of and an estimated total population of about 447million. The EU has often been des ...
reported their households has been in arrears, that is, unable to pay as scheduled "payments related to informal loans from friends or relatives not living in your household".
Businesses
A
company
A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal person, legal or a mixture of both, with a specific objective. Company members share a common p ...
may use various kinds of debt to
finance
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
its
operations as a part of its overall
corporate finance
Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and anal ...
strategy.
A
term loan {{Unreferenced, date=March 2018
A term loan is a monetary loan that is usually repaid in regular payments over a set period of time. Term loans usually last between one and ten years, but may last as long as 30 years in some cases. A term loan usua ...
is the simplest form of corporate debt. It consists of an agreement to lend a fixed amount of money, called the
principal sum
Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...
or principal, for a fixed period of time, with this amount to be repaid by a certain date. In commercial loans
interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct ...
, calculated as a percentage of the principal sum per year, will also have to be paid by that date, or may be paid periodically in the interval, such as annually or monthly. Such loans are also colloquially called "
bullet loan
A bullet is a kinetic projectile, a component of firearm ammunition that is shot from a gun barrel. Bullets are made of a variety of materials, such as copper, lead, steel, polymer, rubber and even wax. Bullets are made in various shapes and ...
s", particularly if there is only a single payment at the end – the "bullet" – without a "stream" of interest payments during the life of the loan.
A
revenue-based financing Revenue-based financing or royalty-based financing (RBF) is a type of financial capital provided to small or growing businesses in which investors inject capital into a business in return for a fixed percentage of ongoing gross revenues, with paymen ...
loan comes with a fixed repayment target that is reached over a period of several years. This type of loan generally comes with a repayment amount of 1.5 to 2.5 times the principle loan. Repayment periods are flexible; businesses can pay back the agreed-upon amount sooner, if possible, or later. In addition, business owners do not sell
equity
Equity may refer to:
Finance, accounting and ownership
* Equity (finance), ownership of assets that have liabilities attached to them
** Stock, equity based on original contributions of cash or other value to a business
** Home equity, the dif ...
or relinquish control when using revenue-based financing.
Lenders
A creditor or lender is a party (e.g., person, organization, company, or government) that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property ...
that provide revenue-based financing work more closely with businesses than bank lenders, but take a more hands-off approach than
private equity
In the field of finance, the term private equity (PE) refers to investment funds, usually limited partnerships (LP), which buy and restructure financially weak companies that produce goods and provide services. A private-equity fund is both a ty ...
investors
An investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Type ...
.
A
syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan. A syndicated loan is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers. Loan syndication is a
risk management tool that allows the lead banks
underwriting
Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liabilit ...
the debt to reduce their risk and free up lending capacity.
A company may also issue
bonds, which are debt
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
. Bonds have a fixed lifetime, usually a number of
year
A year or annus is the orbital period of a planetary body, for example, the Earth, moving in its orbit around the Sun. Due to the Earth's axial tilt, the course of a year sees the passing of the seasons, marked by change in weather, the hou ...
s; with long-term bonds, lasting over 30 years, being less common. At the end of the bond's life the money should be repaid in full. Interest may be added to the end payment, or can be paid in regular installments (known as
coupons
In marketing, a coupon is a ticket or document that can be redeemed for a financial discount or rebate when purchasing a product.
Customarily, coupons are issued by manufacturers of consumer packaged goods
or by retailers, to be used in r ...
) during the life of the bond.
A
letter of credit
A letter of credit (LC), also known as a documentary credit or bankers commercial credit, or letter of undertaking (LoU), is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exp ...
or LC can also be the source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. They are also used in the
land development
Land development is the alteration of landscape in any number of ways such as:
* Changing landforms from a natural or semi-natural state for a purpose such as agriculture or housing
* Subdividing real estate into lots, typically for the purpose ...
process to ensure that approved public facilities (streets, sidewalks, stormwater ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the
advising bank
An advising bank (also known as a notifying bank) advises a beneficiary (exporter) that a letter of credit (L/C) opened by an issuing bank for an applicant (importer) is available. An advising bank's responsibility is to authenticate the letter ...
of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to
giros and
traveler's cheque
A traveller's cheque is a medium of exchange that can be used in place of hard currency. They can be denominated in one of a number of major world currencies and are preprinted, fixed-amount cheques designed to allow the person signing it to ma ...
. Typically, the documents a beneficiary has to present in order to receive payment include a
commercial invoice,
bill of lading
A bill of lading () (sometimes abbreviated as B/L or BOL) is a document issued by a carrier (or their agent) to acknowledge receipt of cargo for shipment. Although the term historically related only to carriage by sea, a bill of lading may toda ...
, and a document proving the shipment was insured against loss or damage in transit. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin.
Companies also use debt in many ways for
capital expenditure
Capital expenditure or capital expense (capex or CAPEX) is the money an organization or corporate entity spends to buy, maintain, or improve its fixed assets, such as buildings, vehicles, equipment, or land. It is considered a capital expenditure ...
s and other business
investment
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing i ...
s made in their
asset
In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
s, "leveraging" the return on their
equity
Equity may refer to:
Finance, accounting and ownership
* Equity (finance), ownership of assets that have liabilities attached to them
** Stock, equity based on original contributions of cash or other value to a business
** Home equity, the dif ...
. This
leverage
Leverage or leveraged may refer to:
*Leverage (mechanics), mechanical advantage achieved by using a lever
* ''Leverage'' (album), a 2012 album by Lyriel
*Leverage (dance), a type of dance connection
*Leverage (finance), using given resources to ...
, the proportion of debt to equity, is considered important in determining the riskiness of an investment; the more debt per equity, the riskier.
Governments
![1979 $10,000 Treasury Bond](https://upload.wikimedia.org/wikipedia/commons/3/3f/1979_%2410%2C000_Treasury_Bond_.jpg)
Governments issue debt to pay for ongoing expenses as well as major capital projects.
Government debt
A country's gross government debt (also called public debt, or sovereign debt) is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit oc ...
may be issued by sovereign states as well as by local governments, sometimes known as municipalities.
Debt issued by the government of the United States, called
Treasuries, serves as a reference point for all other debt. There are deep, transparent, liquid, and open capital markets for Treasuries. Furthermore, Treasuries are issued in a wide variety of maturities, from one day to thirty years, which facilitates comparing the interest rates on other debt to a security of comparable maturity. In finance, the theoretical "
risk-free interest rate
The risk-free rate of return, usually shortened to the risk-free rate, is the rate of return of a hypothetical investment with scheduled payments over a fixed period of time that is assumed to meet all payment obligations.
Since the risk-free ra ...
" is often approximated by practitioners by using the current yield a Treasury of the same duration.
The overall level of indebtedness by a government is typically shown as a ratio of
debt-to-GDP. This ratio helps to assess the speed of changes in government indebtedness and the size of the debt due.
The United Nations
Sustainable Development Goal 17
Sustainable Development Goal 17 (SDG 17 or Global Goal 17) is about "partnerships for the goals." One of the 17 Sustainable Development Goals established by the United Nations in 2015, the official wording is: "Strengthen the means of implement ...
, an integral part of the
2030 Agenda has a target to address the external debt of highly indebted poor countries to reduce debt distress.
Municipalities
Municipal bonds (or muni bonds) are typical debt obligations, for which the conditions are defined unilaterally by the issuing municipality (local government), but it is a slower process to accumulate the necessary amount. Usually, debt or bond financing will not be used to finance current operating expenditures, the purposes of these amounts are local developments, capital investments, constructions, own contribution to other credits or grants.
Assessments of creditworthiness
Income metrics
The
debt service coverage ratio is the ratio of income available to the amount of debt service due (including both interest and principal amortization, if any). The higher the debt service coverage ratio, the more income is available to pay debt service, and the easier and lower-cost it will be for a borrower to obtain financing.
Different debt markets have somewhat different conventions in terminology and calculations for income-related metrics. For example, in mortgage lending in the United States, a
debt-to-income ratio
In the consumer mortgage industry, debt-to-income ratio (often abbreviated DTI) is the percentage of a consumer's monthly gross income that goes toward paying debts. (Speaking precisely, DTIs often cover more than just debts; they can include pri ...
typically includes the cost of mortgage payments as well as insurance and property tax, divided by a consumer's monthly income. A "front-end ratio" of 28% or below, together with a "back-end ratio" (including required payments on non-housing debt as well) of 36% or below is also required to be eligible for a conforming loan.
Value metrics
The
loan-to-value ratio
The loan-to-value (LTV) ratio is a financial term used by lenders to express the ratio of a loan to the value of an asset purchased.
In Real estate, the term is commonly used by banks and building societies to represent the ratio of the first mo ...
is the ratio of the total amount of the loan to the total value of the
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
securing the loan.
For example, in mortgage lending in the United States, the loan-to-value concept is most commonly expressed as a "
down payment
Down payment (also called a deposit in British English), is an initial up-front partial payment for the purchase of expensive items/services such as a car or a house. It is usually paid in cash or equivalent at the time of finalizing the transactio ...
." A 20% down payment is equivalent to an 80% loan to value. With home purchases, value may be assessed using the agreed-upon purchase price, and/or an
appraisal.
Collateral and recourse
A debt obligation is considered secured if creditors have recourse to specific
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
. Collateral may include claims on tax receipts (in the case of a government), specific assets (in the case of a company) or a home (in the case of a consumer). Unsecured debt comprises financial obligations for which creditors do not have recourse to the
asset
In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
s of the borrower to satisfy their claims.
Role of rating agencies
Credit bureaus collect information about the borrowing and repayment history of consumers. Lenders, such as banks and credit card companies, use
credit scores to evaluate the potential risk posed by lending money to consumers. In the United States, the primary credit bureaus are
Equifax
Equifax Inc. is an American multinational consumer credit reporting agency headquartered in Atlanta, Georgia and is one of the three largest consumer credit reporting agencies, along with Experian and TransUnion (together known as the "Big Thr ...
,
Experian
Experian is an American–Irish multinational data analytics and consumer credit reporting company. Experian collects and aggregates information on over 1 billion people and businesses including 235 million individual U.S. consumers and more t ...
, and
TransUnion
TransUnion is an American consumer credit reporting agency. TransUnion collects and aggregates information on over one billion individual consumers in over thirty countries including "200 million files profiling nearly every credit-active consum ...
.
Debts owed by governments and private corporations may be rated by
rating agencies
A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may ra ...
, such as
Moody's
Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corporation, representing the company's traditional line of business and its historical name. Moody's Investors Service provides international ...
,
Standard & Poor's
S&P Global Ratings (previously Standard & Poor's and informally known as S&P) is an American credit rating agency (CRA) and a division of S&P Global that publishes financial research and analysis on stocks, bonds, and commodities. S&P is con ...
,
Fitch Ratings
Fitch Ratings Inc. is an American credit rating agency and is one of the " Big Three credit rating agencies", the other two being Moody's and Standard & Poor's. It is one of the three nationally recognized statistical rating organizations (NRSRO) ...
, and
A. M. Best
AM Best is an American credit rating agency headquartered in Oldwick, New Jersey, that focuses on the insurance industry. Both the U.S. Securities and Exchange Commission and the National Association of Insurance Commissioners have designate ...
. The government or company itself will also be given its own separate rating. These agencies assess the ability of the debtor to honor his obligations and accordingly give him or her a
credit rating
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
...
. Moody's uses the letters ''Aaa Aa A Baa Ba B Caa Ca C'', where ratings ''Aa-Caa'' are qualified by numbers 1-3. S&P and other rating agencies have slightly different systems using capital letters and +/- qualifiers. Thus a government or corporation with a high rating would have Aaa rating.
A change in ratings can strongly affect a company, since its cost of
refinancing
Refinancing is the replacement of an existing debt obligation with another debt obligation under a different term and interest rate. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic ...
depends on its
creditworthiness
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
. Bonds below Baa/BBB (Moody's/S&P) are considered
junk or high-risk bonds. Their high risk of default (approximately 1.6 percent for Ba) is compensated by higher interest payments. Bad Debt is a loan that can not (partially or fully) be repaid by the debtor. The debtor is said to
default on their debt. These types of debt are frequently repackaged and sold below face value. Buying junk bonds is seen as a risky but potentially profitable investment.
Debt markets
Market interest rates
Loans versus bonds
Bonds are debt
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
, tradeable on a
bond market
The bond market (also debt market or credit market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, b ...
. A country's regulatory structure determines what qualifies as a security. For example, in North America, each security is uniquely identified by a
CUSIP
A CUSIP is a nine-digit numeric (e.g. 037833100 for Apple) or nine-character alphanumeric (e.g. 38259P508 for Google) code that identifies a North American financial security for the purposes of facilitating clearing and settlement of trades. ...
for trading and settlement purposes. In contrast,
loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that d ...
s are not securities and do not have
CUSIP
A CUSIP is a nine-digit numeric (e.g. 037833100 for Apple) or nine-character alphanumeric (e.g. 38259P508 for Google) code that identifies a North American financial security for the purposes of facilitating clearing and settlement of trades. ...
s (or the equivalent). Loans may be sold or acquired in certain circumstances, as when a bank
syndicates
A syndicate is a self-organizing group of individuals, companies, corporations or entities formed to transact some specific business, to pursue or promote a shared interest.
Etymology
The word ''syndicate'' comes from the French word ''syndicat ...
a loan.
Loans can be turned into securities through the
securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling ...
process. In a securitization, a company sells a pool of assets to a securitization trust, and the securitization trust finances its purchase of the assets by selling
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
to the market. For example, a trust may own a pool of home
mortgages
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pu ...
, and be financed by
residential mortgage-backed securities. In this case, the asset-backed trust is a debt issuer of
residential mortgage-backed securities.
Role of central banks
Central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
s, such as the U.S.
Federal Reserve System
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
, play a key role in the debt markets. Debt is normally denominated in a particular
currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
, and so changes in the valuation of that currency can change the effective size of the debt. This can happen due to
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
or
deflation
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflation ...
, so it can happen even though the borrower and the lender are using the same
currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
.
Criticisms
Some argue against debt as an instrument and institution, on a personal, family, social, corporate and governmental level. Some
Islamic banking
Islamic banking, Islamic finance ( ar, مصرفية إسلامية), or Sharia-compliant finance is banking or financing activity that complies with Sharia (Islamic law) and its practical application through the development of Islamic economic ...
forbids lending with interest even today. In hard times, the cost of servicing debt can grow beyond the debtor's ability to pay, due to either external events (income loss) or internal difficulties (poor management of resources).
Debt with an associated interest rate will increase through time if it is not repaid faster than it grows through interest. This effect may be termed
usury
Usury () is the practice of making unethical or immoral monetary loans that unfairly enrich the lender. The term may be used in a moral sense—condemning taking advantage of others' misfortunes—or in a legal sense, where an interest rate is ch ...
, while the term "usury" in other contexts refers only to an excessive rate of interest, in excess of a reasonable profit for the
risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
accepted.
In international legal thought,
odious debt
In international law, odious debt, also known as illegitimate debt, is a legal theory that says that the national debt incurred by a despotic regime should not be enforceable. Such debts are, thus, considered by this doctrine to be personal debts ...
is debt that is incurred by a regime for purposes that do not serve the interest of the state. Such debts are thus considered by this doctrine to be personal debts of the regime that incurred them and not debts of the state. International
Third World debt
The debt of developing countries usually refers to the external debt incurred by governments of developing countries.
There have been several historical episodes of governments of developing countries borrowing in quantities beyond their abilit ...
has reached the scale that many
economist
An economist is a professional and practitioner in the social sciences, social science discipline of economics.
The individual may also study, develop, and apply theories and concepts from economics and write about economic policy. Within this ...
s are convinced that
debt relief Debt relief or debt cancellation is the partial or total forgiveness of debt, or the slowing or stopping of debt growth, owed by individuals, corporations, or nations.
From antiquity through the 19th century, it refers to domestic debts, in particu ...
or
debt cancellation Debt relief or debt cancellation is the partial or total forgiveness of debt, or the slowing or stopping of debt growth, owed by individuals, corporations, or nations.
From antiquity through the 19th century, it refers to domestic debts, in particu ...
is the only way to restore global equity in relations with the
developing nation
A developing country is a sovereign state with a lesser developed industrial base and a lower Human Development Index (HDI) relative to other countries. However, this definition is not universally agreed upon. There is also no clear agreem ...
s.
Excessive debt accumulation has been blamed for exacerbating economic problems. For example, before the
Great Depression
The Great Depression (19291939) was an economic shock that impacted most countries across the world. It was a period of economic depression that became evident after a major fall in stock prices in the United States. The economic contagio ...
, the
debt-to-GDP ratio
In economics, the debt-to-GDP ratio is the ratio between a country's government debt (measured in units of currency) and its gross domestic product (GDP) (measured in units of currency per year). While it is a "ratio", it is technically measured i ...
was very high. Economic agents were heavily indebted. This excess of debt, equivalent to excessive expectations on future returns, accompanied asset bubbles on the stock markets. When expectations corrected, deflation and a
credit crunch
A credit crunch (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit cr ...
followed.
Deflation
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflation ...
effectively made debt more expensive and, as Fisher explained, this reinforced deflation again, because, in order to reduce their debt level, economic agents reduced their
consumption
Consumption may refer to:
*Resource consumption
*Tuberculosis, an infectious disease, historically
* Consumption (ecology), receipt of energy by consuming other organisms
* Consumption (economics), the purchasing of newly produced goods for curren ...
and investment. The reduction in demand reduced business activity and caused further unemployment. In a more direct sense, more
bankruptcies also occurred due both to increased debt cost caused by deflation and the reduced demand.
At the household level, debts can also have detrimental effects — particularly when households make spending decisions assuming income will increase, or remain stable, in years to come. When households take on credit based on this assumption, life events can easily change indebtedness into over-indebtedness. Such life events include unexpected unemployment, relationship break-up, leaving the parental home,
business failure __NOTOC__
Business failure refers to a company ceasing operations following its inability to make a profit or to bring in enough revenue to cover its expenses. A profitable business can fail if it does not generate adequate cash flow to mee ...
, illness, or home repairs. Over-indebtedness has severe social consequences, such as financial hardship, poor physical and mental health, family stress, stigma, difficulty obtaining employment, exclusion from basic financial services (
European Commission
The European Commission (EC) is the executive of the European Union (EU). It operates as a cabinet government, with 27 members of the Commission (informally known as "Commissioners") headed by a President. It includes an administrative body o ...
, 2009), work accidents and industrial disease, a strain on social relations (Carpentier and Van den Bosch, 2008), absenteeism at work and lack of organisational commitment (Kim ''et al.'', 2003), feeling of insecurity, and relational tensions.
Levels and flows
Global debt
underwriting
Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liabilit ...
grew 4.3 percent year-over-year to during 2004.
History
According to historian
Paul Johnson, the lending of "food money" was commonplace in
Middle East
The Middle East ( ar, الشرق الأوسط, ISO 233: ) is a geopolitical region commonly encompassing Arabian Peninsula, Arabia (including the Arabian Peninsula and Bahrain), Anatolia, Asia Minor (Asian part of Turkey except Hatay Pro ...
ern civilizations as early as 5000 BC.
Religions like Judaism and Christianity for example, demand that debt be forgiven on a regular basis, in order to prevent systemic inequities between groups in society, or anyone becoming a specialist in holding debt and coercing repayment. An example is the Biblical
Jubilee year
A jubilee is a particular anniversary of an event, usually denoting the 25th, 40th, 50th, 60th, and the 70th anniversary. The term is often now used to denote the celebrations associated with the reign of a monarch after a milestone number of ...
, described in the
Book of Leviticus
The book of Leviticus (, from grc, Λευιτικόν, ; he, וַיִּקְרָא, , "And He called") is the third book of the Torah (the Pentateuch) and of the Old Testament, also known as the Third Book of Moses. Scholars generally agree ...
. Similarly, in
Deuteronomy
Deuteronomy ( grc, Δευτερονόμιον, Deuteronómion, second law) is the fifth and last book of the Torah (in Judaism), where it is called (Hebrew: hbo, , Dəḇārīm, hewords Moses.html"_;"title="f_Moses">f_Moseslabel=none)_and_th ...
chapter 15 and verse 1 states that debts be forgiven after seven years.
This is because biblically debt is seen as both the creditor and debtor responsibility. Traditional Christian teaching holds that a lifestyle of debt should not be normative; the
Emmanuel Association
__NOTOC__
The Emmanuel Association of Churches is a Methodist denomination in the conservative holiness movement.
The formation of the Emmanuel Association is a part of the history of Methodism in the United States. It was formed in 1937 as a res ...
, a
Methodist
Methodism, also called the Methodist movement, is a group of historically related denominations of Protestant Christianity whose origins, doctrine and practice derive from the life and teachings of John Wesley. George Whitefield and John's b ...
denomination in the
conservative holiness movement
The conservative holiness movement is a loosely defined group of theologically conservative Christian denominations with the majority being Methodists whose teachings are rooted in the theology of John Wesley, and a minority being Quakers (Frie ...
, for example, teaches: "We are to refrain from entering into debt when we have no reasonable plan to pay. We are to be careful to meet all financial engagements promptly when due, if at all possible, remembering that we are to 'Provide things honest in the sight of all men' and to 'owe no man any thing, but to love one another' (Romans 12:17; 13:8)."
Further reading
* World Bank, 2019
''Global Waves of Debt: Causes and Consequences'' Edited by M. Ayhan Kose, Peter Nagle, Franziska Ohnsorge, and Naotaka Sugawara.
See also
*
Debt theory of money
*
Debt deflation
Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. Bank assets fall because of the defaults an ...
*
World debt The global debt is 305 trillion US $ in 2022, including debt by public and private debtors. (A trillion is defined here as a million millions, or 1012.)
This debt consists of
* 23% private household debt
* 38% private debt of non-financial corporat ...
References
{{Authority control
Credit
Personal financial problems
Financial law