The sum of money owed by one person and due to another person is called DEBT. The word “debt” is acquired from an old French word ‘dette’ which means a commitment.
A debt policy allows the borrowing party to borrow money on the agreement that it must be repaid at a later point in time, typically with interest. Many businesses and individuals have been using debt to finance major transactions that they otherwise would not be able to afford.
Loans with or without mortgages and credit card debts are some of the most popular types of debts. One person can loan debt to another at a fixed or a floating income of interest. So, the principal amount and the interest amount, along with the period of repayment, would be returned by the borrower. Mortgage loans, car loans, credit card debt, and income taxes are some of the most common forms of debts owed by households and individuals.
In the case of individuals, debt is a way to use a predicted income merged with the future purchasing power before earning the same at present. On the other hand, corporates have a large number of options when it comes to debt. Debts are of two types Long-term debts and Short-term debts. Debts can be used by the companies for their working capital or day-to-day capital. Instead, they may look into the capital structure and may include debt in it, for example, term loans or bonds.
Financing solutions are divided into two categories:
- Letter of Credit.
Letter of Credit is an undertaking by an issuing bank on behalf of the buyer that it will pay the due amount to the seller upon presentation of required documents according to terms and conditions of the letter of credit even if the buyer defaults. Banks play a vital role in simplifying loans, acting as lenders, and are monitored by the Reserve Bank of India (RBI).
TYPES OF DEBT:
Debt is categorized into four: secured debt, unsecured debt, revolving debt, and mortgage.
Secured debt is debt that has been backed up by a specific asset. Debtor’s typically demand that the collateral is property or assets worth enough to support the debt. Vehicles, homes, shares or bonds, and investments are all kinds of collateral. These things are pledged as insurance, and liability is placed on the agreement. The collateral will be sold or liquidated if the borrower defaults, with the funds raised toward repaying the loan.
Secured debt, like most other forms of debt, also necessitates a screening process to evaluate the borrower’s credit scores and capacity to repay. The ability to repay can also require checking the collateral and evaluating its worth, in addition to the typical analysis of income and employment position.
Debt that doesn’t need any collateral as insurance is referred to as unsecured debt. The creditworthiness of the debtor and his or her capacity to repay are assessed beforehand. Due to the lack of a collateral allocation, the debtor’s credit profile would be the primary criterion used to accept or reject credit.
Unsecured debt includes credit cards, car loans, and student loans, to name a few. The amount loaned is often determined by the debtor’s economic state, which includes how much they receive, how much liquid cash they have on hand, and their employment status.
A revolving debt account is a credit line or a sum that a debtor can use over and over again. To put it another way, the debtor will lend up to a limit, repay, and then lend up to that amount again.
Credit card debt is the most popular cause type of revolving debt. The arrangement gets started when the cardholder extends a credit line to the debtor. The credit line is valid for as long as the account is active as long as the borrower meets their liabilities. The amount of revolving debt can keep increasing if you have a good repayment history.
A mortgage is a loan often used to buy real estates, such as a home or a condominium. Since the subject real estate is used as loan collateral, this is a type of secured debt. Mortgages, however, are very different from other debts from the category.
Companies looking to borrow money have other functional alternatives than credit cards and loans. Corporate entities have access to debt forms that individuals do not have, such as commercial paper and bonds.
Bonds are a type of debt instrument that allows businesses to raise money by offering a redemption guarantee to interested investors. Bonds with a predetermined interest rate, or discount, may be purchased by institutions and private investment organizations.
Bond investors are promised a face value on a certain date, known as the maturity date after they buy the bonds. This amount is in addition to the bond’s daily interest earned during its active time.
Bonds operate on the same basis as traditional loans, with the exception that the business is the borrower and the investors are the lenders or creditors.
A short-term loan with a maturity date of less than or equal to 270 days is known as commercial paper.
Secured vs. Unsecured Debt
Secured debts require both a guarantee of repayment and collateral. Securing a loan means putting up collateral that can be sold if a creditor defaults and the money owed is not repaid.
Mortgages and car loans are examples of secured loans since the collateral is the object being financed. For example, if a borrower is buying a car and defaults on payments, the lender may sell the car to recuperate the balance. The property is often used as leverage if a person takes out a mortgage.
Unsecured debt, on the other hand doesn’t quite require any kind of safeguard or collateral. However, if a borrower fails to repay the loan, the lender can file charges in court to recover the money owed. Creditworthiness is used by lenders to determine a borrower’s ability to repay a loan.
Good Debt vs. Bad Debt
There are several sectors in the market, and each has its association with debt. As a result, each organization uses scales specific to its sector to determine the appropriate level of debt. Several criteria are used to determine whether a company’s debt level is within a reasonable range when assessing its financials.
Good debt allows a person or corporation to effectively manage their finances, making it easier to improve on established wealth, buy what is required, and plan for the future. Mortgages, purchasing goods and services that save the consumer money, school loans, and debt restructuring are all examples of this.
Bad debt, on the other hand, is a contract whose value drops significantly soon after it is signed. However, the definition applies to the majority of the essential items in our lives, such as automobiles, televisions, and clothing. Credit card loans and payday loans are two common examples.
Advantages and Disadvantages of Debt:
The amount of debt owed by a company receives a lot of attention in the area of corporate finance. If a company’s profits decline for whichever cause, and it is no longer as profitable as it used to be, it may be unable to repay its debts. A business in this situation is at risk of going bankrupt. A company that does not take out loans, on the other hand, could be restricting its potential growth.
Obtaining debt from a financial institution helps businesses to raise the funds they need to complete specific tasks or programs. In contrast to shareholders’ participation in a company’s management, debt financiers have no say in how the company operates. In addition, interest is tax-deductible. Interest payments on mortgages are tax-deductible, but not on standard consumer debt.
Debt is used differently in various sectors because the “best” amount of debt differs from company to company. Various criteria are used to decide whether a company’s amount of debt, or leverage, used to finance operations is within a reasonable range when determining its financial standing.
If the creditor defaults on the deal, the collateral used to protect the loan could be confiscated. Consumers and companies with too much debt could be deemed too risky to be eligible for new debt, restricting access to additional funds to meet other commitments and responsibilities, even though they adhere to the terms.
- Injects money into ventures to help them get off the ground.
- Tax liabilities are reduced.
- Exposure to new opportunities is increased.
- Increases the chances of bankruptcy.
- Assets that have been collateralized are compromised.
- When a borrower has too much debt, he/she gets restricted from taking on more debt.
Read Next: “ETF’s vs. Index Funds“
For more information, reach us at [email protected]