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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,
company, or an individual.
Commercial debt is generally subject to contractual terms regarding the amount
and timing of repayments of principal and interest.[1] loans, bonds, notes, and
mortgages are all types of debt. In financial accounting, debt is a type of
financial transaction, as distinct from equity. The term can also be used
metaphorically to cover moral obligations and other interactions not based on a
monetary value.[2] 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.[3]
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 [was used] after c. 1400.[4] The related term
"debtor" was first used in English also in the early 13th century;
the terms "dettur, dettour, [came] 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 "Principal (finance)"
For the principal of a bond, see Bond (finance) § Principal. Principal is
the amount of money originally invested or loaned, on which basis interest and
returns are calculated.[5] 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 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 mortgages and credit cards.
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,
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:
Individuals:
Common types of debt owed by individuals and households include mortgage loans,
car loans, credit card debt, and income taxes. 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.[6][7][8][9][10]
This is primarily because of the transparency effect and consumer's "pain
of paying."[8][10] 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.[10] 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.[8] 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.[9][11]
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".[12]
Businesses:
A company may use various kinds of debt to finance its operations as a part of
its overall corporate finance strategy. 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 loans",
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.[13]
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 years; 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 giros 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
assets, "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 1979:
U.S. Government $10,000 treasury bond:
Main article: Government debt:
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.[14] 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.[15] 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.[16] 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 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 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 assets 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, Experian, 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.
Debt markets:
Market interest rates:
Main article: Bond valuation Loans versus bonds:
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, loans are not securities and do not have
CUSIPs (or the equivalent). Loans may be sold or acquired in certain
circumstances, as when a bank syndicates a loan. 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:
Central banks, 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 or deflation, so it can happen even
though the borrower and the lender are using the same currency.
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Criticisms:
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 accepted. 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 economists[who?]
are convinced that debt relief or debt cancellation is the only way to restore
global equity in relations with the developing nations.[citation needed]
Excessive debt accumulation[clarification needed] has been blamed for
exacerbating economic problems[by whom?]. 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
followed. 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 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,[17] 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.[18]
Levels and flows:
Main article: Debt levels and flows:
Global debt underwriting grew 4.3 percent year-over-year to US$5.19 trillion
during 2004.[citation needed] History Main article: History of money See also:
Interest § History According to historian Paul Johnson, the lending of
"food money" was commonplace in Middle Eastern 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.[19] Similarly, in Deuteronomy chapter 15 and verse 1 states
that debts be forgiven after seven years.[20] 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, a Methodist denomination in the
conservative holiness movement, 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)."[21]
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