Debt
A debt is something that can be borrowed. Usually, in a debt agreement, one party borrows money from the other party with the condition that it will be paid back with interest at a later date. Some large purchases require large sums of money, so many corporations and individuals use debts.
Understanding Debt
Debts are most often represented by loans. Mortgages, credit card debt, car and personal loans are the most widespread. Payment of credit debts should be done by a fixed date. Usually, it takes several years to repay a loan balance. The terms of the loan also prescribe the amount of annual interest. Interest is compensation to the lender for the risk involved in the loan. It pushes the borrower to pay back the loan quickly to limit the overall interest expense.
Credit card debt is similar to a loan. The only thing is the form of debt in which the amount can change over time (within a predetermined limit). It depends on the borrower's needs. Credit card debt can have a rolling or open-ended repayment date. Some types of credit can be combined (for example, personal and student loans).
Types of Debt
Most debts can be classified into 4 categories: secured, unsecured, revolving debts or mortgages.
Secured debt. This type of debt has collateral in the form of property (cars, houses, boats) or assets (securities, investments) whose value can cover the sum of the debt. Such an agreement includes a lien, and the collateral serves as security. If the obligations are not met, the collateral is taken or sold, and the money from the sale pays off the loan.
Before any kind of loan, the borrower's creditworthiness and ability to pay is checked. And this type of loan requires checks on income, employment status, and ability to pay. Also, checking the collateral and assessing its value may be required.
Unsecured debt. In this case, you don't need collateral. As with any other loan, creditworthiness, debtor's ability to repay, financial situation, amount of earnings, amount of liquid money and employment status are checked. The size of the loan also depends on them. Creditworthiness is the deciding factor in approving or denying a loan. Unsecured loans include credit cards, student loans, and car loans.
Revolving debt. It is an amount that a borrower can borrow for an extended period of time. This refinancing credit line allows to use the money up to a certain amount, pay it back, and borrow it again up to that amount. The most common refinancing debt is credit card debt. By agreement of the parties, if the credit card holder meets his or her obligations and repays the amount of revolving debt, the line of credit is active.
Mortgages. This is a debt obligation to buy real estate (a house or an apartment). It is similar to secured debt because the property is considered collateral for the loan, but mortgage loans have their own peculiarities. First, a mortgage has a very long amortization period (15 to 30 years). Second, it is one of the largest loans except student loans. Third, there are many types of mortgages, and the requirements for choosing the type of mortgage differ greatly.
Mortgage loans come in many different forms and depend on many small factors. For example, there are conventional loans, Federal Housing Administration (FHA) loans, rural development loans, adjustable-rate mortgages (ARMs), etc. Such a loan can be taken with a basic credit rating, but the type of mortgage affects the set of minimum requirements.
Corporate Debt
Companies have other debt options as well. For example, individuals do not have access to such types of debts as bonds and commercial papers. They are corporate debts.
Bonds are corporate debt obligations to attract money from investors for a promise to pay them back. Bonds have a certain coupon (interest) rate. Both individuals and companies can buy bonds. For example, a company needs $1 million to buy new equipment. That company can issue 10,000 bonds that are valued at $100 to attract money from investors.
Bondholders receive regular interest payments over the next several years. They accept the promise to pay the face value of the bond on a certain date in the future. This date is called the maturity date.
The function of bonds is similar to loans, except that in this case the investors are the lenders and the company is the borrower.
Pros and cons of Debt
The amount of corporate debt is very important in corporate finance. The less debt a company has, the less opportunity it has to expand its business. The more debt a company has, the less ability it has to pay interest when sales fall, the higher the chance of bankruptcy.
The company's stockholders have access to the management of the company. The financier of the debt does not have access to the management of the company, and the interest expense is tax deductible. That is, the company can spend capital to complete certain tasks or projects. Individuals do not have interest expense deductible for a conventional consumer loan, but they do for a mortgage.
Different companies in different industries have different "correct" amounts of debt. A certain company evaluates its financial situation according to different indicators. This helps to determine the level of debt or leverage in financing operations. They should be within acceptable limits.
If the debt is secured by collateral, the collateral can be confiscated if the borrower doesn't meet his or her obligations. Also, having a large corporate debt may cause a refusal to get new debt. This reduces access to additional funds to meet other obligations and liabilities.