What Is Debt?
Gold is the currency of kings,
Silver is the money of gentlemen,
Barter is the money of peasants,
Debt is the money of slaves.
According to historians, the first debts were the lending of “food money” which was commonplace in Middle Eastern civilizations as early as 5000 BCE, so debt has been around for over 7 thousand years.
Today debt is an amount of money borrowed by one party from another. Debt is used by many corporations and individuals as a method of making large purchases that they could not afford under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that the loan is to be paid back at a later date, usually with interest. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase.
Under the terms of the loan, the borrower is required to repay the balance of the loan by a certain date, typically several years in the future. The terms of the loan also stipulate the amount of interest that the borrower is required to pay annually, expressed as a percentage of the loan amount. Interest is used as a way to ensure that the lender is compensated for taking on the risk of the loan while also encouraging the borrower to repay the loan quickly in order to limit his total interest expense. There are two ways to conquer and enslave a country. One is by the sword. The other is by debt.
Credit card debt operates in the same way as a loan, except that the borrowed amount changes over time according to the borrower’s need, up to a predetermined limit, and has a rolling, or open-ended, repayment date.
Common types of debts owed today by individuals and households include mortgage loans, car loans, credit card debt, and income taxes. For individuals, debt is a means of using anticipated income and future purchasing power today in the present before it has actually been earned. Commonly, people in industrialized nations use consumer debt to purchase houses, cars and other things too expensive to buy with cash on hand.
People are more likely to spend more and get into debt when they use credit cards vs. cash for buying products and services. This is primarily because of the transparency effect and consumer’s “pain of paying.” The transparency effect refers to the fact that the further you are from cash (as in a credit card or another form of payment), the less transparent it is and the less you remember how much you spent. The less transparent or further away from cash, the form of payment employed is, the less an individual feels the “pain of paying” and thus is likely to spend more. Furthermore, the differing physical appearance/form that credit cards have from cash may cause them to be viewed as “monopoly” money vs. real money, luring individuals to spend more money than they would if they only had cash available.
Besides these formal bank debts, private individuals also lend informally to other people, mostly relatives or friends. One reason for such informal debts is that many people, in particular those who are poor, have no access to affordable credit. Such debts can cause problems when they are not paid back according to expectations of the lending household. In 2011, 8 percent of people in the European Union reported their households have been in arrears, that is, unable to pay back as scheduled of the “payments related to informal loans from friends or relatives not living in their household”.
Debtors of every type default on their debt from time to time, with various consequences depending on the terms of the debt and the law governing default in the relevant jurisdiction. If the debt was secured by specific collateral, such as a car or home, the creditor may seek to repossess the collateral. In more serious circumstances, individuals and companies may go into bankruptcy.
Credit bureaus collect information about the borrowing and repayment history of consumers. Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers. In the United States, the primary credit bureaus are Equifax, Experian, and TransUnion.
Central banks, such as the U.S. Federal Reserve System, play a key role in the debt markets. Debt is normally denominated in a particular currency, and so changes in the valuation of that currency can change the effective size of the debt. This can happen due to inflation or deflation, so it can happen even though the borrower and the lender are using the same currency.
At the personal individuals level, debts can also have detrimental effects — particularly when households make spending decisions assuming income will increase, or remain stable, in years to come. When households take on credit based on this assumption, life events can easily change indebtedness into over-indebtedness.
Such life events include unexpected unemployment, relationship break-up, leaving the parental home, business failure, illness, or home repairs. Over-indebtedness has severe social consequences, such as financial hardship, poor physical and mental health, family stress, stigma, difficulty obtaining employment, exclusion from basic financial services, work accidents and industrial disease, a strain on social relations, absenteeism at work and lack of organisational commitment, feeling of insecurity, and relational tensions.