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What is debt in simple words?

The definition of debt is ‘an obligation that requires the debtor to pay the money to their creditor.’ Debt is nothing but the amount of money one borrows. In other words, it is the money one spends that isn’t theirs. For example, taking a loan from a bank, making credit card purchases, etc. Large corporations also borrow money to finance their projects and for other business needs.

The most common types of debt are loans and credit cards. In addition to these, corporate borrowings are known as corporate debt. Also, bond and commercial paper are the common types of corporate debt instruments that are not usually available to individuals. Bonds are a type of debt instrument that enables a company to raise funds by selling the promise of repayment to its investors. On the other hand, a commercial paper is a short term debt instrument with a maturity of 270 days or less.

A debt agreement is an agreement that permits the borrowing party to borrow money with an obligation to pay back at a later date, usually with interest. Moreover, one perceives debt as a negative concept. However, with proper planning and management, one can benefit by taking debt to meet their requirements.

What is the difference between loan and debt?

Loan and debt are terms often used interchangeably due to the reason that they both primarily mean borrowing money. However, there is a small difference between the two. A loan is money borrowed from a lender. On the other hand, debt is the money raised through the issuance of bonds or debentures.

A loan is money one borrows from a lender. The lender can be a bank or a financial institution. Moreover, a loan is more structured in terms of payment, and the principal amount is paid back to the borrower in instalments over a period of time. Also, loans are usually taken by people for their personal uses. However, even companies take loans to run their businesses.

The definition of debt is the money that the company raises through the issuance of bonds and debentures. Governments, companies, trusts, or corporations can issue bonds to fund their business, and the lender, in this case, will be the investor. The investor will receive interest payment regularly until the bond or debenture matures. Also, upon maturity, the investor gets back the entire principal amount in lump sum.

What is the difference between stock and securities?

Securities are investments that are easily convertible to cash. On the other hand, stocks are one type of securities. Some of the other types of securities are bonds, ETFs, futures and options, banknotes, real estate, etc. Most securities trade on the exchange or in the secondary market.

Stocks are securities not different, just that stocks are a type of securities. Securities are broadly classified as ownership securities, debt securities and derivative securities. Ownership securities are stocks. Debt securities are notes and bonds. Derivatives securities derive value from the price fluctuations or changes of other securities or commodities.

A stock is one type of security that belongs to the equity class. An investor would always invest across multiple securities to have diversification to their portfolio and to address volatility (risk). Investing in just one asset class like stocks would lead to high fluctuations in the portfolio returns. On the other hand, having investments across different securities will help in generating good returns in all market scenarios.

Stocks represent an ownership interest in a company; on the other hand, securities like debt allow the borrower to borrow funds, derivative securities for hedging or speculative purposes.

What are the types of security?

Security is a financial instrument. Different parties trade securities in the open market. Following are the four different types of securities:

Equity Securities

Equity refers to stocks and shares. It represents the ownership interest held by shareholders in a company. The earnings of a shareholder are usually in the form of dividends. Also, listed equity securities are volatile and are the prices rise or fall as per the market conditions.

Debt Securities

Debt or fixed income securities represent that the money is borrowed and shall be repaid with interest upon maturity. These securities include government bonds, certificate of deposits, corporate bonds, treasury bills etc. These are bought and sold with a promise to repay the same with interest. Also, the debt agreement predetermines the rate of interest, the amount borrowed, the maturity and renewal date.

Derivative Securities

The value of derivatives securities depends on the underlying asset. The underlying asset can be stocks, bonds, interest rates, market indices, interest rates, or goods. It is a contract between two or more parties. Where the value of the investment is derived from underlying financial assets. The main purpose of derivatives is to minimise risk. One can achieve it by insuring against the price fluctuations. The different types of derivatives are future, forwards, options, and swaps.

Hybrid Securities

Hybrid security is a type of security that has both debt and equity securities characteristics. Many institutions use hybrid securities to borrow money from investors. Examples of hybrid securities are convertible bonds, where the bondholder can convert to equity stocks during the bond tenure or at maturity. Preferred stocks, these allow the holder to receive dividends prior to common stockholders.

What are the 5 components of credit score?

One can calculate their credit score using the following 5 components

  • Loan repayment history
  • Credit Utilisation Ratio (CUR)
  • Credit mix
  • Duration of credit
  • Number of credit enquiries

Loan repayment history

The loan repayment history of an individual affects their credit score. A credit information company keeps track of all payments towards loans, bills and EMI. One single non-payment or late payment can drag down the credit score by 100 points.

Credit Utilisation Ratio (CUR)

CUR measures the usage of available credit in the credit card. The more the ratio, higher will be the reduction in the credit score of an individual. Ideally, the CUR should be below 30% to maintain a good credit score.

Credit mix

The type of credit mix impacts an individual’s credit score. A healthy mix of secured and unsecured loans will help in maintaining a good credit score. Having too many unsecured loans might drag the credit score down.

Duration of credit

Duration of a credit line is one of the components of credit score. Older the loan, better the credit score as it shows the individual’s responsibility to the creditors in making timely payments.

Number of credit enquiries

The number of credit enquires affect the credit score. Individuals themselves make soft enquiries, and that doesn’t affect the score. However, lenders make hard enquiries after a legal permit is obtained. Too many enquiries might show the individual is credit hungry and might drag the credit score down.

Published on October 27, 2020