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 debt may be owed by sovereign state
or country, local government
, or an individual. Commercial debt is generally subject to contractual term
s regarding the amount and timing of repayments of principal
, notes, and mortgages
are all types of debt. In finance
, debt is one of the primary financial instrument
s, especially as distinct from equity
The term can also be used metaphorically to cover moral
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.
The English term "debt" was first used in the late 13th century. The term "debt" comes from "dette, from Old French
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
after c. 1400. The related term "debtor" was first used in English also in the early 13th century; the terms "dettur, dettour, ame
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
, only one spelling, "debtor", is used.
Principal is the amount of money originally invested or loaned, on which basis interest and returns are calculated.
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
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
" at maturity. Amortization structures are common in mortgage
s and credit card
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
, 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
Types of borrowers
Common types of debt owed by individuals and households include mortgage loan
s, car loans, credit card
debt, and income tax
es. For individuals, debt is a means of using anticipated income
and future purchasing power
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
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".
may use various kinds of debt to finance
as a part of its overall corporate finance
A term loan
is the simplest form of corporate debt. It consists of an agreement to lend a fixed amount of money, called the principal sum
or principal, for a fixed period of time, with this amount to be repaid by a certain date. In commercial loans interest
, 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
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
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
or relinquish control when using revenue-based financing. Lenders
that provide revenue-based financing work more closely with businesses than bank lenders, but take a more hands-off approach than private equity investors
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
the debt to reduce their risk and free up lending capacity.
A company may also issue bonds
, which are debt securities
. Bonds have a fixed lifetime, usually a number of year
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
) during the life of the bond.
A letter of credit
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
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
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 giro
s and traveler's cheque
. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice
, bill of lading
, 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 to leverage the investment
made in their asset
s, "leveraging" the return on their equity
. This leverage
, the proportion of debt to equity, is considered important in determining the riskiness of an investment; the more debt per equity, the riskier.
Governments issue debt to pay for ongoing expenses as well as major capital projects. Government debt
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
" 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
, an integral part of the 2030 Agenda
has a target to address the external debt of highly indebted poor countries to reduce debt distress.
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
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
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.
The loan-to-value ratio
is the ratio of the total amount of the loan to the total value of the collateral
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
." 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 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
s of the borrower to satisfy their claims.
Role of rating agencies
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
, and TransUnion
Debts owed by governments and private corporations may be rated by rating agencies
, such as Moody's
, Standard & Poor's
, Fitch Ratings
, and A. M. Best
. 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
. 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
depends on its creditworthiness
. 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.
Market interest rates
Loans versus bonds
are debt securities
, tradeable on a bond market
. A country's regulatory structure determines what qualifies as a security. For example, in North America, each security
is uniquely identified by a CUSIP
for trading and settlement purposes. In contrast, loan
s are not securities
and do not have CUSIP
s (or the equivalent). Loans may be sold or acquired in certain circumstances, as when a bank syndicates
Loans can be turned into securities through the securitization
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
to the market. For example, a trust may own a pool of home mortgages
, 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
s, such as the U.S. Federal Reserve System
, play a key role in the debt markets. Debt is normally denominated in a particular currency
, and so changes in the valuation of that currency can change the effective size of the debt. This can happen due to inflation
, so it can happen even though the borrower and the lender are using the same currency
Some argue against debt as an instrument and institution, on a personal, family, social, corporate and governmental level. Some Islamic banking
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
, 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 international legal thought, odious debt
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
has reached the scale that many economist
s are convinced that debt relief
or debt cancellation
is the only way to restore global equity in relations with the developing nation
Excessive debt accumulation has been blamed for exacerbating economic problems. For example, before the Great Depression
, the debt-to-GDP ratio
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
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
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
, 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
, 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
grew 4.3 percent year-over-year to during 2004.
According to historian Paul Johnson
, the lending of "food money" was commonplace in Middle East
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
, described in the Book of Leviticus
. Similarly, in Deuteronomy
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.
* Debt theory of money
* Debt deflation
Category:Personal financial problems