What is Debt?

Debt is an amount owed for funds borrowed. The lender agrees to lend funds to the borrower upon a promise by the borrower to pay interest on the debt, usually with the interest to be paid at regular intervals. A person or business acquires debt in order to use the funds for operating needs or capital purchases. In a business, debt may also be used as the source of funds for buying back shares in the business or to acquire another organization.

Secured and Unsecured Debt

Debt may be secured by an entity's other assets, which will become the lender's property if the entity cannot pay back the debt. Alternatively, the debt may be unsecured. Debt may also be guaranteed by a third party, such as an owner or a corporate parent. If the borrower defaults on a loan, the guaranteeing party is obligated to pay for the outstanding amount of debt.

Debt Covenants

A lender may impose certain covenants as part of a debt agreement, such as a requirement that a current ratio of at least 2:1 be maintained, or that no dividends be paid as long as the debt is outstanding. If the borrower breaches a covenant, the lender is permitted to call the loan, thereby forcing its immediate repayment by the borrower.

Advantages of Debt

There are several advantages to the use of debt, which are as follows:

Maintain ownership interest. The borrower can use it to avoid selling additional ownership shares, so that ownership remains concentrated with the current set of investors. This is an especially important consideration for family-run businesses.
Interest tax deduction. Interest expense is tax deductible, so its net cost to the borrower can be comparatively low.
Possible incremental return on investment. If the borrower uses borrowed funds to purchase assets that generate a reasonable return, it can earn a net gain over the cost of the funds acquired.
Reduced cost of capital. Debt financing often costs less than equity financing. This is because lenders require lower returns than equity investors (as debt is usually less risky), making it a more affordable way to raise capital.
May improve creditworthiness. Managing debt responsibly can build creditworthiness, leading to better interest rates and borrowing terms in the future. A strong credit profile can be an asset when seeking larger loans or favorable financing terms.

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Types of Debt

There are many types of debt, of which the most common are noted below:

Secured debt. Secured debt is backed by collateral, such as a house or car, which the lender can seize if the borrower defaults. This type of debt typically carries lower interest rates due to reduced lender risk.
Unsecured debt. Unsecured debt is not tied to any specific asset and is based solely on the borrower’s creditworthiness. It usually carries higher interest rates since the lender has no collateral to claim in case of default.
Revolving debt. Revolving debt allows borrowers to repeatedly borrow up to a certain limit, repay, and borrow again, such as with credit cards or lines of credit. It offers flexibility but often comes with higher interest rates.
Installment debt. Installment debt is repaid in fixed payments over a set period, such as mortgages or auto loans. It provides predictable repayment schedules and often lower interest rates than revolving debt.
Convertible debt. Convertible debt is a type of loan that can be converted into equity, typically in a company’s stock, under certain conditions. It is often used in startup financing to delay valuation decisions.
Subordinated debt. Subordinated debt ranks below other debts in terms of claims on assets in the event of liquidation. It carries higher risk and therefore usually higher interest rates.
Senior debt. Senior debt is prioritized for repayment in case of bankruptcy or liquidation, giving it lower risk and lower interest rates. It is often secured and has strict covenants.