What Is Debt?

Debt 101

First Published Date : October 9, 2010 ADawnJournal.com

Something that seems to dominate our lives is debt. Debt routinely influences the lives of individuals, allowing them to buy things, or preventing them from buying things they want or need. As the years have gone by, the debt load of people in the Western World has increased greatly. While most people had little debt in the 1950s and 60s, but the 1990s and 2000s, people owed more money than they made, which is a very bad situation to be in. So, what is debt and how does it influence our lives so much?

Debt is something that is owed to someone else. It can mean money that is owed, or a moral obligation that is owed. Either way, it is something that must be repaid. Like a favour, you are agreeing to pay or do something for someone else at a future date because you are in his or her debt. A debt is created when a creditor agrees to give a lump sum of assets to a debtor. The debtor agrees to repay the debt with interest in most cases.

The word debt itself comes from the French word dette, which itself comes from the Latin word debere, which means to owe. In the 17th century, the letter b was put into the word debt in Samuel Johnson’s dictionary.

When a debt is made, the debtor and creditor must agree on the manner in which the debt is going to be repaid, this is a deferred payment. The payment is typically a certain amount of money that will help pay off the debt, or it could be the entire debt at once. Payment of increments of a debt over time is one of the most common forms of repayment, but repayment in full at the end of the loan agreement is also very common these days as well.

There are several types of debt that you should be aware of when dealing with debt:

1.   Secured Debt – This is debt that is made against some sort of collateral. For example, you agree to put up your house as collateral when you get a loan for your business. If you do not repay your business loan, you lose your house. Secured debt typically has lower interest rates because the risk is less.

2.   Unsecured Debt – This debt is not against any sort of collateral and therefore has a greater risk for the creditor. As a result, interest rates are higher for this and one’s credit score must be good to obtain this credit.

3.   Private Debt: This is a bank-loan obligation.

4.   Public Debt: This is a general definition that covers freely tradable debt on a public exchange with few restrictions.

5.   Basic Debt: This is the simplest form of debt and is just an agreement to lend someone a sum of money over a certain period of time, which must be repaid at a certain date.

6.   Syndicated Loan: This is a loan granted to companies who want to borrow more money than a single lender is prepared to risk. Therefore, the loan comes from several lenders at once and typically runs into the millions of dollars.

7.   Bond Debt: A bond is a debt security that is issued by certain institutions such as companies and governments. This bond entitles the person who holds it to repay the principle sum, plus interest.

There are other forms of debt that many people and companies use to help them manage day-to-day.

1.   Cash credit: This is the primary method in which a bank will get money for the security of debt. It is like a current account except the money that can be withdrawn is done so without restriction to the amount that is deposited.

2.   Working capital: Firms need money to pay for day-to-day activities like paying wages, buying supplies and more. This is the working capital of the company and the main source of working capital is the current assets the company can use to generate money.

3.   Bank overdraft: When you withdraw more money than you have in your bank account, you will often go into your overdraft, which is money lent to you by the bank. You will have a negative balance on your account, which must be repaid at some point.

Debt has a lot to do with credit worthiness. The better your credit, the more of a debt you can take on. Typically, if you have a FICO score above 600, you will be able to accumulate more and more debt, and anything between 350 and 599 will mean you will have difficulty getting debt until you manage your credit better. Companies also have the same type of system for when they borrow money. The best credit rating for a company is AAA, while the worst is C.

When debt becomes too much, one of the most common things for people to do is file for bankruptcy, which is one of the only ways that a debt can be removed without repayment. A debtor cancelling the debt is very rare, but becoming more common especially during the economic crisis. In fact, many economists feel that the only way for developing nations to reach equity with developed nations is for their immense debt load to be erased. As for individuals, many will try debt consolidation or debt counselling, which will allow them to repay their debts without having to declare bankruptcy. The problem with declaring bankruptcy is that it will destroy a credit rating for several years, often as long as seven years in total.

Debt is a big fixture of our lives these days and not something that is going to disappear any time soon. The only way to manage debt properly is to be smart with debt and make sure that it does not become something that causes you to fall behind. Be smart with debt and it will not overload you and make your life less than what you want it to be.