Understanding Debt

A debt is created when one individual called a creditor, lends an asset – usually money – to another individual called a debtor. Here “individual” can be a person, a business, an organization or a country. The transaction is usually recorded in a formal document or contract that has legal standing, even if written on the back of a napkin. Such documents have different names such as notes, bills, bonds, mortgages, student loans, and an vast array of other terms. These names are usually collectively referred to as debt instruments.

We now consider various aspects and forms of debt.

Let’s consider the simplest of bonds. A bond documents the payment of a specific amount of money from the buyer or creditor to the bond issuer or debtor, usually a government or a business. As with most types of loans, bonds specify at least the following four things:

  1. The principal or the amount of the loan. The term capital is sometimes used to refer to the money lent.
  2. The maturity or term or duration of the loan. This is the length of time after which the loan must become fully repaid.
  3. The frequency, composition and amount of payments. A bond may specify semi-annual payments of interest only. A mortgage may specify monthly payments of interest and principal repayment.
  4. The interest to be paid on the loan. This covers the risk of loss of capital due to inflation or default (bankruptcy), plus an amount for the use or rent of the creditor’s capital.

Who Owns Your Home?

An important aspect of debt is that it is an asset to the creditor and a liability to the debtor. As a mortgage lender or mortgagee, you not only have a reasonable expectation that the borrower or mortgagor will make all required payments, but you will have registered a claim called a lien, against the underlying property’s title in case of default. Although the mortgagor or debtor has title to the property, in the case of default of payment, the lein gives you the right to foreclose on and seize the property.

Securing an asset in this way is called hypothecation. The worst case is you will own the home.

As a mortgagor, it is hard to think of your house as a liability, but until the mortgage is fully discharged, it may be such.

Let’s suppose you decide to sell your house at market value. Through your monthly payments which have slowly repaid part of the original principal of the loan, you have equity built up in your house. You may also have made a down-payment at the time of purchase for part of the value, adding to your equity.

If the market value of the house is greater than the amount of principal remaining on your mortgage, hopefully by at least your invested equity, then congratulations! Your house is an asset to you measured by the difference between the two figures. If the remaining principal is greater than the market value, you will still owe money to the mortgagor after the sale. Your house is therefore a liability to you by that amount that would be owed.

Another aspect of debt is that unless the instrument forbids it, the debt may be sold by the creditor to another party. This is common practice in the finance world with mortgages, car loans, student loans, etc. In fact, it was the sale of mortgages to investment banks that then repackaged the loans into complex financial instruments known as collateralized debt obligations (CDO) and mortgage-backed securities (MBS) that was responsible for the severity of the 2007 financial crisis.

The terms asset and liability are accounting terms and are usually associated with an accounting instrument called a balance sheet. We mention this because in other contexts in which we explore debt, we have to introduce balance sheets (hopefully in a simple and non-frightening manner). There are many things we have been willing to tackle in life but medical issues, auto mechanics and accounting remain for us, the black arts.

The Significance of Debt to the Debtor

A debtor takes on debt on the basis of a reasonable expectation they will be able to repay the debt from future income.

Suppose your total or gross income is $2,000 per month and your bills, fixed payments, and necessities are on the average, $1,700 per month. The $300 difference is your net income available to spend on luxuries – things you want at the moment beyond what you really need, such as new clothes, dining out, a new cell phone. You decide to buy a small second car. You arrange a loan in which you will pay $250 per month over the next 5 years.

You can handle the payments OK, but your net income after expenses has gone from $300 to $50. After the novelty of the second car wears off and while the additional operating expenses are sinking in, you suddenly feel much poorer. You can’t eat out any more or buy new electronic toys. Your standard of living has decreased measurably. And this will last for 5 years barring a raise at work. Worse, inflation could turn your situation into a nightmare.

Debt transfers income and standard of living from the future into the present where it is immediately consumed in the acquisition of something. Future opportunity to do or acquire something beneficial are lost because the ability to purchase them has been transferred to the present time acquire whatever the loan was for.

A Point About Bonds

We have said that the price of a bond moves in the opposite direction of the market interest rates.

Let’s briefly consider why. When you buy a 2% 10 year $100 bond, you are buying an income stream from the interest payments plus, at the end, a return of your capital, the $100 face value of the bond. At the end of 10 years you expect to have $120 ignoring compounding interest. The next day, interest rates double. $100 now buys a bond that will return $140 after 10 years. You decide you want to sell your 2% bond to buy a higher paying 4% one. The problem is no investor will pay $100 for a $120 return when for $100 they can get a $140 return. You have to sell your 2% $100 bond for $80 to attract a buyer (the $120 the bond will return – the $80 paid gives the buyer the $40 equivalent to the money he would make buying a 4% bond). So bond prices move inversely to interest rates.

The Key Points

  1. Debt is like a coin with two sides. It is an asset to one party, an amount of money owing, and a liability to another party, an amount of money owed.
  2. On the asset side, the money owing is usually backed or secured by some tangible asset such as a car or a house, or a Treasury instrument in the case of the Federal Reserve. The debtor no longer has legal claim on the asset.
  3. Debt transfers future wealth into the present where it is consumed. Not good for our kids and their kids.
  4. Debt is usually denominated in and transacted in units of legal currency. As such, debt can be considered to be a form of money.