Now we all actually aware of the concept of debt. We generally associate it with borrowing money whether it is from a friend, your parents or perhaps the bank. But in economics, it must be defined more accurately for individuals or organizations. Let us take a comprehensive look at the concept of debt.
What is Debt?
Debt is a sum of money borrowed by one entity, namely the borrower from another entity, namely the lenders. Due to the unavailability of liquid cash, Governments, corporations(big and small) and individuals often raise debts to make payments for varied purposes.
For instance, an organization may borrow from a bank or raise money from other sources to fund its working capital requirements. Another instance is a student purchasing an education loan from a bank to fund his/her education. This is a form of contract which allows the borrower to borrow money with the condition that the money is to be paid back at a later date(specified in the agreement), with added interest.
Governments raise debts to cover their deficit finances which help pay for ongoing activities as well as major capital projects. This debt may be issued in the form of loans or by issuing bonds. The analysis to determine the cost of lending to a government is done by analyzing the ratio of debt-to-GDP. This ratio helps to assess the due debt and repayment capacity as well.
Types of Debts
On the basis of availability of security, debts can be classified as:
Secured debts are a type of debt backed that is protected by another asset or any form of guarantee for the purpose of collateral. It often involves a credit check by the lending organization to evaluate credit history. This collateral is handed or pledged to the lender in case the borrower fails to pay back the loan.
An instance of such debt is if you take a loan to buy a car, the lender provides you with the cash to make the purchase it. In addition, the lender also places a lien on the vehicle. If you fail to repay the loan, the lender can take possession of the car and sell it to recover the funds. Secured loans have relatively lower interest rate depending on the value of the collateral.
Unsecured debts are taken in the absence of any collateral. Such loans have an added risk component as it may not be recovered at all. The lender can take legal action to reclaim the sum of money owed. Due to the high-risk component, these loans have relatively higher interest rates.
This type of debt involves a predefined borrowing limit and can be used to avail quick funds. The limit is determined using asset valuation and credit history of the borrower. This type of facility is available on credit cards.
On the basis of the time period of borrowing, it can be classified as:
- Short term: If the period for which the debts are borrowed is less than a year, it is a short-term debt.
- Long-term: If the time period of repayment of the debt is over a year, the debt is long-term in nature.
Assessing Credit Score of the Borrower
Some of the important factors taken into account when the credit score is evaluated for the borrower are:
- The ratio of available income to the amount of debts.
- Availability and value of the collateral.
- Past credit history.
To summarize, debt is used as a financing instrument by different types of organizations. Debt financing may be in the form of equity, bonds or loans. While issuing any kind of debts, a risk assessment is done to analyze the default risk associated with the loan.
On the basis of this if the risk component is high then the interest charged on the loan is high and if the loan is protected by collateral the interest component is relatively lower. The interest also depends on the duration of the loan. Different kinds of debt instruments can be used on the basis of duration period, the urgency of the requirement of funds and so on.
Solved Question for You
Q: What is meant by a short-term loan?
Ans: A short-term loan is one which is taken for a short period of time. generally having a term for less than one year.