Financial obligation that should be paid by the borrower for seeking additional finance from an external source.

Author: Muhammed Ishfaque Ishaque
Muhammed Ishfaque Ishaque
Muhammed Ishfaque Ishaque
Hello there! My name is Muhammed Ishfaque Ishaque. I am based in the United Arab Emirates. And I hold a bachelor's degree (Hons) majoring in accounting and finance from the University of West London. I am passionate about finance, analysis, and management, due to which, I love to enhance my knowledge and expertise in the field. Time never stops, so why should one stop learning and improving.
Reviewed By: Parul Gupta
Parul Gupta
Parul Gupta
Working as a Chief Editor, customer support, and content moderator at Wall Street Oasis.
Last Updated:February 25, 2024

What is Debt?

Debt is defined as a financial obligation that should be paid by the borrower for seeking additional finance from an external source. Alternatively, debt is a borrowed amount that needs to be paid back with interest.

Getting additional funding from commercial institutions or close ones, either way, everyone must have experienced the obligation to pay back the amount borrowed.  

Both individuals and companies alike indulge in procuring debt to cover up expenditures that are unaffordable at a point in time. Therefore, financial providers, such as banks, consider debt to be a financial instrument where they can provide debt services for a fee and interest. 

As mentioned above, debts, especially from commercial entities such as banks, provide debts to facilitate the borrowers’ large expenses for a fee and compounded interest rates, with the prerequisite of principal (borrowed) amount repayment in the future. 

Unless forgiven (less likely from a commercial entity), the debts need to be repaid at a set due date; exceeding it would result in heavy compounding of interest rates, which is better to stay clear unless you want to drown in debt and file at the end bankruptcy.

It's a pretty lucrative idea to milk money out of people. That's how the modern economy runs in debt. Strategically harnessing the debt opens doors to getting wealthy; that is how rich people stay rich. But if the debt goes out of hand, that's how people lose everything, literally (collateral).

It is essential to know what a debt is for a normal person, even if it's just in general, which can pose a great advantage to staying clear of stepping into the unwanted route.

Key Takeaways

  • Debt is a financial obligation representing borrowings that require repayment of a borrowed amount in the future along with additional costs, such as fees and interest rates, often obtained from banks.
  • Individuals and companies use debt to cover expenses beyond their immediate affordability, with financial providers offering debt services for a fee and interest.
  • Pros include facilitating difficult decisions, covering financial obligations, enabling growth, and tax reduction.
  • Practical advice to avoid falling into debt includes budgeting, monitoring finances, having an emergency fund, cutting unnecessary subscriptions, and using credit cards strategically.

How Debt Works

Debt is the obligation a person incurs when he/she borrows a set amount of financial support from a financial provider, which needs to be paid in full amount (principal) at the assigned date along with fees for the service and interest rates for compensating the lender for taking the risk. 

It can be complex money-making schemes or, shall we say, “financial instruments” for commercial entities, or it can be an act of kindness like from family and friends who don't charge any interest rates or any fees. 

Debt can serve both beneficial and detrimental purposes. Good debt can facilitate wealth accumulation, while bad debt can deteriorate one's financial standing. Knowing how to harness the power of debt can help you achieve your dreams; if not, it will be the worst nightmare. 

Corporations and wealthy individuals often maintain debt in a way that the control is in their hands. However, they do not cross the limit of losing control of their debt, which is a great mistake that has the power to make you file bankruptcy.

It's like the author of the book “Rich Dad Poor Dad” Robert T. Kiyosaki, said: “Be careful when you take on debt. If you take on debt personally, make sure it is small. If you take on a large debt, make sure someone else is paying it”. 

But remember, defaulting on promised repayment is not a viable option since the financial institutions can hand over your case to a collection agency, which is a headache of its own. It lowers your credit score and deems you incredible for any financial services in the future.  


In case of default, there is an option of “debt settlement.” It is a last-resort strategy used in the event when bankruptcy is inevitable. This strategy requires a portion payment of the total borrowed and the rest forgiven by the financial provider. But know it lowers your credit score, and you lose any credit services from the financial institutions.

An Example of Debt

Since we have a basic understanding of debt, in theory, financial topics such as debt are better understood with a simple practical use case. So, let us see how it works with a simple, barebones, practical example of you owning a house. 

Suppose you are planning to buy a house to finally settle in with your family; after all, you are in your late 30s. A cozy home caught your eye that costs $480,000, and it has a great neighborhood with quality schools and parks. It is a fantastic deal.  

You made arrangements with the realtor and secured the deal. The realtor requested that you make the 20% down payment upfront to fully finalize the deal and start the paperwork. You paid the $96,000 as a down payment and approached the bank for a mortgage to afford the house. 

The bank agreed to give a secured home loan to cover the rest of the payment with an interest rate of 7.94% over 30 years, resulting in a monthly payment of $2,801 over 30 years. But the catch is since it is a secured loan, the bank will confiscate the house as collateral. 

The amount shown above is inaccurate as many elements, such as housing insurance, brokerage fees, property tax, and whatnot, have been ignored. This illustration is to give insight into how debt works.

Types of Debts

As we are aware, debt comes in many shapes and forms that are targeted toward the specific financial needs of a demographic. Each debt has its rules and regulations, but as long as the borrower is eligible, he/she can approach more than one type of debt. 

Various debts are issued based on the borrower's circumstances. There are chances of potential borrowers getting denied for a financial service, as it is the responsibility of the financial providers to prevent fraud and preserve the chances of receiving back the amount.

In broad, the debts are classified into two categories targeting two broad demographics

  1. Consumer Debt - Debts that common individuals approach to cover heavy financial obligations and expenditures. 
  2. Corporate Debt - Debts that corporations and companies approach for a larger sum of long-term and short-term debt. 

Consumer Debt

Consumer debts are those financial services by financial providers that are often targeted at individuals who require financial assistance in covering their financial obligations and expenditures. 

Options for individual financial assistance are more than that for the corporate. As for individuals, their circumstances of typical financial need don't reach to the extent that of the corporation. This allows banks to afford incentives to assist with individual financial needs. 

Types of Consumer Debt

Below are the most common forms of personal debts available in the financial market to meet various individual financial needs: 

Secured Debt 

Secured debts are backed by collateral, providing security for the lender. These are issued when the borrower places an asset of value which covers the debt (collateral) in case of default. This is why such debts are called collateralized debts, as it reduces risk for lenders.  

Such debts are provided by the financial providers when they do not have enough trust in the borrower, either due to low credit scores or first-time indulgence. The assets that are declared as collateral should be of monetary value that covers the borrowed amount.

Common examples would be car loans and mortgages. The purchased asset (car or house) is kept as collateral, which would then be seized and sold by the bank if the borrower defaults on debt repayment at the due period; for a mortgage, the period can be 15 or 30 years (long-term).  

Unsecured Debt 

Unsecured debts are not secured by the collateral. These debts are issued based on creditworthiness; these debts are issued to borrowers with a trust that the repayment can be made along with interest at the due date.

The higher the creditworthiness, the more trustable the borrower is, and so is vice versa. Credit score, credit history, and other factors determine the creditworthiness level of a person. 

A common example of unsecured debt would be personal loans. These services are provided based on how the borrower treated his/her previous credits. Due to the riskiness of it, the lenders charge higher interest rates than a secured form of debt.

Revolving Debt 

Revolving debts are those that act as a line of credit. The financial providers that grant such debt allow the borrower to utilize the needed credit up to a certain limiting threshold. But what is revolving is that the borrower can use credit again after paying the previous credit.

The borrower is required to make monthly payments to the financial provider for the incurred debt, at least a certain minimum amount, to maintain the credit line and avoid the credit service going inactive. 

Having a record of good credit score or creditworthiness can build a good relationship with the bank, leading to an increased credit threshold. A common example we can notice around us is credit card debt. 

Corporate Debt 

Corporate debts are those debt services provided by financial institutions that are targeted for companies and corporations due to the nature of their heavy financial need. Typically, corporations approach such debts as a strategy or during heavy financial transactions.  

The debt instruments tailored for corporations are different from the debt instruments for individuals. Thus, such debts are restricted to individuals. Various forms of corporate debt provide means for different circumstances for a corporation. 

Types of Corporate Debt

Below are some of the common forms of corporate debts unique to corporations available in the financial markets for a company: 


Bonds are debt instruments utilized by corporations that seek high amounts of debt to assist in difficult financial decisions, such as business expansion. The company issues bonds with interest rates or coupon rates, along with the promise of full repayment at the maturity (due) date.  

Bondholders would be institutions and individual investors who invest in the company’s bonds and deem the bond to be worth their investment based on the offered interest rates, the company’s creditworthiness, and the collateral the company places in. 

Bonds are typically considered secured debt.

Let's say your company wants to set up a new branch. But you require $500,000 for it. Your company has issued 500 bonds with $1,000 per bond. But issuing and receiving are two different things, so to appeal to potential investors, you set a good interest rate and a due date.       


Debentures are another form of debt similar to that of bonds. But the difference lies in whether it is secured or not. Debentures are debt instruments used by companies that typically target the general public for procuring debt.

“Then what is the difference between the two?” I hear you ask. Well, as mentioned before, it lies in whether it is secured or not. The nature of a debenture is unsecured, meaning there is no collateral placed for debentures.

Commercial Paper

Commercial papers are short-term debt indulged by companies for a short-term need or strategy. Typically, a commercial paper comes with a maturity period of less than or equal to 270 days.   

Advantages and Disadvantages of Debt

Consider debts to be a dual-edged sword; a wrong move can cause severe wounds. It has both advantages and disadvantages, but to those who are wise and strategic, it's a total advantage to them. And to those who aren't, well, the system played you. Debts are crafted to put you in debt.

So why don't we jot down the common advantages and disadvantages of utilizing debt? After all, whether you are an individual or a business, the bank, as a commercial entity, will definitely make a buck out of you.


Some of the common advantages of indulging in debt are: 

  1. It allows companies and individuals to fund their projects, which require heavy financial investment, such as starting a business for an individual or business expansion for companies.
  2. It allows individuals and companies alike to cover financial obligations that are due upon them.
  3. Indulging in debt opens new growth opportunities and potentials leading to financial growth (extension of point 1). 
  4. Incurring debt burden allows companies and individuals to reduce tax burdens that are due upon the taxable person (depending on the country’s tax laws).
  5. Acquiring debt is actually pretty convenient for an ordinary person (depending upon the scheme and demanding amount) as this is a plus for banks since they incur a cash inflow.  
  6. Debts can be a real lifesaver during emergency situations where the individual or the company is in desperate need of finance. 
  7. Maintaining a good relationship with the debt (I mean paying at the right time) increases credit score and enhances the individual/company’s creditworthiness, allowing companies/individuals options to acquire large debt. 


The above should give a good glimpse of the advantages of indulging in debt. But it is an illusion as well. Why don’t we see the disadvantages of incurring debt as well? They are as follows: 

  1. Indulging in debt has a high risk of insolvency. When borrowing high finance for a project or plan, if that project defaults, then you have to pay the principal amount along with compounded interest rates along with some fees. 
  2. Interest rates on taking debt can get phenomenal, especially when compounded on the interest rate as well as with the principal amount. 
  3. Due to the high risk of insolvency, there exists a high chance of losing the asset that is kept as collateral, as the bank will most welcomely sell the asset to recover the debt. 
  4. For a company (as well as individuals), taking head-on heavy debt can come at the cost of heavy financial burden, dedicating a significant portion of cash for repayment, thus having less money for daily operations. 
  5. In case of defaulting, it tampers the credit score of the borrower, making the borrower less creditworthy. Due to this, the borrower can't get any additional finances from any financial providers. 
  6. It is a great Michelin star-worthy recipe for bankruptcy. 

How to Pay Off Debt

Now we have a glimpse of what debt is and whether it is really worth your time considering its drastic effect on your life. It is really important to know how NOT to fall into debt, especially when falling into it is as easy as drinking unfiltered water, thinking it's drinkable water. 

Below are the ten pieces of advice that can help you from falling into unwanted debt:

  1. Don't buy what you can't afford today.
  2. Buy the want today, but never pay the want tomorrow unless it is a need.
  3. Paying today is better than paying tomorrow. 
  4. Monitor and budget your finances.
  5. Keep an emergency fund in case of financial fallbacks.
  6. Cut out unwanted subscriptions. 
  7. Pay against the worth of your hard work. 
  8. Cut out unwanted credit lines such as credit cards and use credit cards strategically to increase your credit score only if you have the money today to pay at the month's end.
  9. Coupons are financial life jackets; use them whenever you can to cut out costs.
  10. Reasonable cost cutting should not push you to be unreasonably cheap, nor should reasonable spending should push you to unreasonable overspending and gambling. 

Debt FAQs

Researched and authored by Muhammed Ishfaque Ishaque | LinkedIn 

Reviewed and edited by Parul Gupta | LinkedIn

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