What Is Considered Debt in Accounting and Finance?

Debt is a fundamental concept in finance, representing a widespread method for acquiring assets, funding operations, or managing cash flow. Its use is prevalent across the economy, from individuals making large purchases to corporations funding expansion and governments covering budget deficits. For individuals, debt can be a tool to build wealth through homeownership, while for businesses, it is a source of financing that enables growth. However, it also introduces risks and obligations that must be carefully managed, as the terms can vary widely.

The Core Components of Debt

A debt arrangement involves two primary parties: the debtor, who is the borrower of the funds, and the creditor, who is the lender. The relationship is formalized through a debt instrument, such as a loan agreement or bond, which outlines the specific terms of the repayment. The amount of money originally borrowed is known as the principal.

In nearly all cases, the creditor charges interest, which is the cost of borrowing the principal. Interest is expressed as an annual percentage rate (APR) and represents the compensation the lender receives for taking on the risk of lending the money. The agreement specifies the repayment schedule, including the amount and frequency of payments, and the maturity date.

Failure to make these payments as scheduled is called a default. A default can lead to severe consequences for the debtor, including legal action and damage to their creditworthiness.

Secured vs Unsecured Debt

A primary way to categorize debt is by determining whether it is secured or unsecured. The distinction lies in the presence of collateral, which is a specific asset the borrower pledges to the lender to guarantee repayment. This characteristic changes the risk profile for the lender and the terms offered to the borrower.

Secured debt is backed by a tangible asset that the lender can seize if the borrower fails to make payments. Common examples include mortgages, where the house serves as collateral, and auto loans, where the vehicle is the collateral. Because the collateral reduces the lender’s financial risk, secured loans often have lower interest rates and more favorable terms.

Unsecured debt is not backed by any specific asset. Lenders grant unsecured credit based on the borrower’s creditworthiness, which is an assessment of their income, credit history, and financial stability. Common forms of unsecured debt include credit cards and personal loans. Since there is no collateral to recover, these loans pose a higher risk to the lender, which is reflected in higher interest rates.

Revolving vs Installment Debt

Debt can also be classified by its repayment structure as either installment or revolving credit. A single debt instrument can fall into multiple categories; for instance, a personal loan is typically both an unsecured and an installment debt.

Installment debt involves borrowing a specific, lump-sum amount that is repaid over a set period through fixed payments. These loans have a predetermined term, and the repayment schedule, known as an amortization schedule, outlines how each payment is allocated between principal and interest. Mortgages, auto loans, and student loans are common examples.

Revolving debt provides access to a line of credit with a preset limit that the borrower can draw from as needed. Credit cards and home equity lines of credit (HELOCs) are the most common examples. The borrower can use the funds, repay them, and then borrow again. The required monthly payment varies based on the outstanding balance, and interest is charged only on the amount that has been borrowed.

How Debt is Classified on a Balance Sheet

In accounting, debt is recorded as a liability on a company’s or individual’s balance sheet. A balance sheet provides a snapshot of financial position, and classifying liabilities correctly is important for assessing financial health. The primary distinction is based on the time frame in which the debt is due.

Debt that is due within one year from the date of the balance sheet is classified as a current liability. This category includes short-term obligations such as accounts payable, the outstanding balance on a credit card, and the portion of a long-term loan scheduled to be paid within the next 12 months.

Debt that is due in more than one year is categorized as a non-current or long-term liability. This includes financial obligations like mortgages, long-term business loans, and bonds payable. According to accounting standards like ASC 470, long-term obligations are those scheduled to mature beyond one year.