Reviewed by Jan 05, 2021| Updated on
Back in school, a lot of us would have borrowed a pencil at school to be returned later. As we grow, we began to work to support our family and in turn, achieve our long term goals. Life cannot run smoothly without money. At times, our earnings may not be sufficient to achieve our goals and so we turn to loans and debts at a price.
Debt refers to sum of money owed by one person and due to another person. Most popular kinds of debt are loans with or without mortgages and credit card debt. One person can lend debt to another at a fixed or a floating interest income. So, the borrower will return the principal amount together with the interest amount along the period of loan repayment. The word 'debt' is derived from an old french word 'dette' that means an obligation.
Popular types of debt owed by households and individuals are mortgage loans, car loans, credit card debt, and income taxes. In the case of individuals, debt is a way to use an anticipated income combined with the future purchasing power at present before earning the same.
On the other hand, corporates have a multitude of options when it comes to debt. Debts can be short term or long term. Companies may use debt for their working capital or day-to-day operations. Alternatively, they may look into the capital structure and may include debt in it, such as term loans or bonds. Letter of Credit and Guarantee are other types of financing options.
Banks play an essential role in facilitating loans, acting as lenders and are regulated by the Reserve Bank of India (RBI).
It is imperative to learn about two terms 'Good Debt' and 'Bad Debt' to know about the importance of debt. How much debt the company or individual can afford to take depends upon its/his financial standing or the difference in asset and liability. A debt that can be repaid without a default is a 'Good Debt'. A company having a large amount of debt may be unable to fulfil interest payments if its sales fall. It will, therefore, be putting the business in danger of insolvency. It may eventually be a 'Bad Debt'. On the opposite side, a company that does not make use of debt may miss opportunities for business expansion.
Hence, debt is significant for a person to have an active credit score. Usually, the cost of debt is lower when compared to raising equity. Also, the risk involved in financing debt is low compared to equity. When analysed from the investors point of view, a company is obligated to repay the debt to the investor as compared to a shareholder during times of insolvency and bankruptcy.