Debt

Definition:

Debt refers to an amount of money borrowed by one party from another, which is expected to be paid back at a future date. It often involves regular, fixed repayments over a specified period or in lump-sum at the end of the term. Types of debt include mortgages, personal loans, corporate bonds, and government bonds.

When an individual or organization requests money from an institution or another individual, a debt is created upon agreement. Generally, the terms include interest payments along with the principal amount. Debt can be categorized into secured and unsecured debt, depending on the requirement of collateral.

Examples:

Personal Loan: Individual A borrows $10,000 from a bank to fund a home renovation, agreeing to repay the amount in monthly installments over five years, plus interest.
Student Loan: Jordan obtains a loan to cover college tuition, with an agreement to start repaying the loan after graduation over a predefined period.
Corporate Bond: Company XYZ issues bonds to investors to raise capital for business expansions. The company agrees to pay back the principal after a set period, along with regular interest payments.
Government Bond: The government issues bonds to investors to fund public projects or manage national debt, promising to pay back the principal at maturity with periodic interest payments.

Frequently Asked Questions (FAQs):

Q: What is the difference between secured and unsecured debt?
A: Secured debt is backed by collateral, meaning the borrower pledges an asset (like a house or car) as security for the loan. If the borrower defaults, the lender can seize the collateral. Unsecured debt has no collateral, and lenders rely solely on the borrower’s creditworthiness, resulting in higher interest rates due to the increased risk.

Q: How is debt different from equity?
A: Debt involves borrowing money that must be repaid, typically with interest, whereas equity involves selling ownership stakes in an asset or company in exchange for capital. Debt incurs a fixed obligation, while equity does not mandate repayment but dilutes ownership control.

Q: What does ‘default’ mean in the context of debt?
A: Default occurs when the borrower fails to meet the legal obligations or conditions of a loan, typically by failing to make scheduled payments or breaching covenants. Default can lead to legal action and seizure of secured collateral.

Q: Why do companies issue debt instead of using equity financing?
A: Companies may prefer debt because interest payments are tax-deductible, reducing the overall cost of capital. Moreover, taking on debt allows companies to retain complete ownership and control, whereas equity financing dilutes ownership interest.

Q: What factors determine the interest rate on debt?
A: Interest rates on debt are influenced by the borrower’s creditworthiness, the loan amount, term length, economic conditions, market interest rates, and whether the debt is secured or unsecured.

Principal: The original amount borrowed in a loan or the face value of a bond.
Interest: The cost of borrowing money, expressed as a percentage of the principal, paid periodically.
Credit Score: A numerical evaluation of a borrower’s creditworthiness, influencing loan approval and interest rates.
Collateral: An asset pledged by the borrower to secure a loan, which can be seized in case of default.
Bankruptcy: A legal process for individuals or businesses unable to repay outstanding debts, leading to asset liquidation or reorganization.

Online Resources:

References:

Brigham, Eugene F., and Michael C. Ehrhardt. Financial Management: Theory & Practice. Cengage Learning, 2016.
Ross, Stephen A., Randolph W. Westerfield, and Bradford D. Jordan. Corporate Finance. McGraw-Hill Education, 2018.

Suggested Books for Further Studies:

Principles of Corporate Finance by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
Debt Markets and Analysis by R. Stafford Johnson
The Financial Times Guide to Understanding Finance by Javier Estrada

Real Estate Basics: Debt Fundamentals Quiz

### What is debt? - [x] An obligation to pay money or other agreed-upon value - [ ] An investment in real estate - [ ] A type of savings account - [ ] Ownership of a property > **Explanation:** Debt is an obligation to pay money or other agreed-upon value to another party. ### What is secured debt backed by? - [ ] The borrower's name - [ ] Borrower's employment status - [x] Collateral - [ ] Market conditions > **Explanation:** Secured debt is backed by collateral, meaning an asset pledged by the borrower as security for the loan. ### Which type of debt does not have collateral? - [x] Unsecured debt - [ ] Secured debt - [ ] Convertible debt - [ ] Subordinated debt > **Explanation:** Unsecured debt has no collateral; lenders rely solely on the borrower's creditworthiness. ### What does it mean to default on a debt? - [ ] Having the loan forgiven - [x] Failing to meet the legal obligations of a loan - [ ] Getting a better interest rate - [ ] Doubling the payments > **Explanation:** Default occurs when the borrower fails to meet the legal obligations or conditions of a loan, such as missing scheduled payments. ### How can companies benefit from issuing debt instead of equity? - [x] Interest payments are tax-deductible - [ ] It grants them more equity - [ ] It does not need to be paid back - [ ] It is costless > **Explanation:** Interest payments on debt are tax-deductible, reducing the overall cost of borrowing, unlike dividends paid on equity. ### What influences the interest rates on debt? - [ ] Only the borrower's employment - [x] Borrower's creditworthiness, loan amount, term length, and market rates - [ ] The lender’s preferred rates - [ ] Past borrowing history continuity > **Explanation:** Interest rates are influenced by multiple factors including the borrower's creditworthiness, loan amount, term length, and prevailing market interest rates. ### Who are typical lenders providing debt? - [ ] Community centers - [x] Banks, credit unions, and financial institutions - [ ] Family and friends (under formal conditions) - [ ] Charitable organizations > **Explanation:** Traditional lenders include banks, credit unions, and financial institutions, while family and friends under informal settings are not conventional lenders. ### What financial term is used to describe the original amount borrowed on a debt? - [ ] Interest - [x] Principal - [ ] Collateral - [ ] Bond Value > **Explanation:** The original amount borrowed on a debt is referred to as the principal. ### How does collateral benefit the lender? - [ ] By offering a discount on the loan - [ ] Making the loan tax-free - [x] It reduces lender's risk of loss - [ ] Increases the interest rate > **Explanation:** Collateral benefits the lender by reducing the risk of loss in case the borrower defaults on the loan; the lender can seize the collateral. ### Why might bankruptcy be declared by a borrower? - [ ] To increase their loan amount - [ ] For a better investment opportunity - [x] When unable to repay outstanding debt - [ ] To extend their repayment tenure > **Explanation:** Bankruptcy is declared when an individual or business is unable to repay outstanding debts, leading to asset liquidation or restructuring of the debt.