August 8, 2022

Types of Debt

Debt is an obligation by one party (the debtor) to provide an agreed upon financial benefit to another party (the creditor), usually by an agreed upon date. This obligation is usually created by a transaction in the present that conveys economic benefit to the debtor that creates a liability that must be settled in the future, signifying an outflow of economic benefit in the future. For individuals it allows spending more than one’s income in return for having to spend far less than one’s income in the future, due to the loan repayments. For businesses, it is almost a necessity as it allows access to large amounts of capital which may be needed for business activities and allows businesses to exploit opportunities and earn greater profits than their existing capital allows. Debt can be classified to different types based on the time period as well as the nature of debt. Long-term and short-term debt is a classification that uses the payback period of debt and is used by businesses to classify debt in their financial statements. Secured and Unsecured debt is another classification based on the recourse available to the creditor if the debtor defaults on the payment.This article describes several types of debt from an individual as well as business perspective.

Unsecured Debt

Unsecured debt refers to debt given to a debtor without any collateral binding the debtor to ensure payment. Provision of this debt carries higher risk to the creditor which results in the interest rates being higher to compensate for this. Unsecured debt provides no recourse for the creditor if the debtor refuses or is unable to repay the loan. Businesses have the option of employing the services of organisations such as Gold Coast Debt Collector to attempt recovery of uncertain debts, although if the debtor is genuinely unable to pay (such as in cases of bankruptcy), the debt is simply written off.

Secured Debt

In contrast to unsecured debt, secured debt usually has an asset tied to the debt agreement where if the debtor fails to repay the loan, the creditor has the right to lay claim to the underlying asset or the amount due from the value of the underlying asset. This is commonly seen in leasing arrangements and mortgages where failure to repay the loan results in the repossession of the vehicle or the house to which the debt is tied. Since the creditor faces less risk when providing secured debt, they often have lower interest rates.

Long-term and Short-term debts

This is almost exclusive to businesses as short-term and long-term debt is classified depending on whether the loan is due in one financial year or not. Businesses take short-term loans such as overdrafts to meet working capital needs and long-term debt such as bonds and bank loans for long-term strategic needs. Collection agencies generally operate on short term debts as they are less complicated to transfer. Since loan interest in tax deductible, businesses often maintain a balance in their debt-to-equity ratios that favours debt in order to maximise business profitability.

Leave a Reply

Your email address will not be published. Required fields are marked *