Debt

What Is Debt?

Debt is an arrangement in which one party borrows money or other value from another and agrees to repay it, usually over time. The borrower, often called the debtor, receives funds today and takes on an obligation to return them, typically with interest paid to the lender as compensation for waiting and for accepting the risk of non-payment. On the borrower's balance sheet, debt is a liability. For the lender, the same obligation is an asset.

Debt appears throughout the economy. Households use it for mortgages, car loans, student loans, and credit cards. Companies borrow from banks or issue bonds to fund operations and expansion. Governments sell debt securities to finance spending that taxes do not fully cover.

How Debt Works

Most debt has three basic parts: the principal, which is the amount borrowed; the interest rate; and a repayment schedule. For simple interest, the cost of borrowing can be estimated with this formula:

Interest = Principal × Interest Rate × Time

For example, borrowing 1,000 at a 5 percent annual rate for one year costs 50 in interest. Some loans are repaid through regular installments that gradually reduce the balance, a process known as amortization. Other debt, such as many bonds, pays interest periodically and returns the full principal on a set maturity date.

Debt is also classified by whether it is backed by assets. Secured debt is backed by collateral, such as a house in a mortgage, which the lender can claim if the borrower fails to pay. Unsecured debt, such as most credit card balances, has no specific collateral, so lenders usually charge higher rates to offset the added risk.

Why Debt Matters to Investors

Borrowing can help a person or business grow, for example by financing a home or a new factory. However, debt creates fixed payments that must be made regardless of income, and missed payments can lead to default. Investors often examine how much a company owes relative to its equity using a debt-to-equity ratio, and credit agencies publish a credit rating that signals the likelihood of repayment.

In a bankruptcy, creditors are generally paid before shareholders, which is one reason bonds are often considered less risky than stock issued by the same company. Tax rules can also treat interest differently from other expenses, and the details vary by country.