A debt instrument is a contract that enables one party to loan funds to another party, who promises to repay the loan plus interest. Debt instruments are also referred to as fixed-income assets because the lender receives a fixed amount of interest during the lifetime of the instrument.
Debt instruments come in many forms. Some are obvious, such as mortgages and different types of small business loans; while others are less so, such as rental leases, bonds, and treasuries. With some debt instruments, you are the borrower (such as when you take out a mortgage or credit card). In other cases, you are the lender, such as when you purchase a bond or treasury.
Here’s what you need to know about debt instruments, the different types of debt instruments, how these instruments work, and the pros and cons of debt financing.
What Are Debt Instruments?
A debt instrument is a fixed income asset that legally binds a debtor to pay back any amount borrowed plus interest. Debt instruments can be issued by individuals, businesses, local and state governments, and the U.S. government.
Businesses often use debt instruments to raise capital to purchase additional assets (such as manufacturing equipment) or to raise working capital, while local governments may do so to fund the building of infrastructure (such as a new highway or a bridge). Debt instruments also give participants the option to transfer the ownership of debt obligation (or instrument) from one party to another.
Debt instruments can be short-term (repaid within a year) or long-term (paid over a year or more). Credit cards and treasury notes are examples of short-term debt instruments, while long-term business loans and mortgages fall into the category of long-term debt instruments.
Recommended: What to Know About Short-Term Business Loans
How Do Debt Instruments Work?
If you’ve ever taken out a loan or credit card, you probably already understand the basics of how debt instruments work. Debt instrument contracts include detailed provisions on the deal, including collateral involved, the rate of interest, the schedule for interest payments, and the term of the loan (or timeframe to maturity).
While any type of vehicle classified as debt can be considered a debt instrument, the term is most often applied to debt capital raised by institutions, such as companies and governments. In this scenario, the investor is the lender: You issue money to a business, municipality, or the U.S. government. In exchange for capital, you are paid back the amount you loaned over time with interest. Examples of this type of debt instrument include U.S. treasuries, municipal bonds, and corporate bonds.
Recommended: Lease or Purchase Equipment
Types of Debt Instruments
Below is a breakdown of some of the most common debt instruments used by individuals, governments, and companies to raise capital.
US Treasuries
U.S. Treasury securities (also called treasuries) are government debt instruments issued by the U.S. Department of the Treasury to finance government spending as an alternative to taxation. Treasury securities are backed by the full faith and credit of the U.S., meaning that the government promises to raise money by any legally available means to repay them.
U.S. treasuries tend to be more affordable than many other debt instruments. Investors can buy them in increments of $100 either through brokerage firms, banks, or the U.S. Treasury website. There are three types of treasuries: treasury bills, treasury notes, and treasury bonds. Each treasury comes with its own maturity option.
Municipal Bonds
Municipal bonds are offered by various U.S. government agencies (towns, cities, counties, or states) to fund current and future expenditures. Programs often funded by municipal bonds include the building of schools, roads, and bridges. Think of a municipal bond as a loan an investor makes to a local government.
There are two types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are not paid back by any revenue resulting from the completion of the project. Instead, they are paid back to investors through property taxes or overall general funds.
Revenue bonds are paid back by the issuer through either sales, taxes, or some other type of revenue generated by the project.
Municipal bonds are attractive to many investors because they are tax exempt bonds — meaning the investor doesn’t have to pay taxes on any interest received.
Corporate Bonds
A corporate bond is a debt security that a corporation can use to raise money. Funding is typically available to anyone who is interested. As with other bonds, corporate bonds are essentially an IOU from the company to the investor. It differs from stock in that, instead of being paid dividends when the company is profitable, investors are always paid regardless of whether the company is doing well.
Typically, corporate bond investors are paid interest until the bond matures. When it matures, the entire principal is paid back. For example, a $1,000 corporate bond with an interest rate (or coupon rate) of 5%, would bring an investor $50 every year until the bond matures. This means that, after 10 years, the investor would see a gross return of $500.
With secured bonds, the company puts up collateral (such as property or equipment) as security for the bond. If the company defaults, secured bond holders can foreclose on the collateral to reclaim their money. With an unsecured bond, a holder may or may not be able to fully reclaim their investment.
Alternative Structured Debt Security Products
There are many types of structured debt security products on the market, many of which are issued by financial institutions. A common occurrence is for these institutions to bundle assets together as a single debt security product. By doing this, they are able to raise capital for the financial institution while also segregating the bundled assets.
Recommended: Single and Multi Step Income Statements
Leases
A residential or commercial lease is a legally binding contract between an owner of a property and a tenant where the tenant agrees to pay money for a set period of time in exchange for use of the rented property. A lease is a type of debt instrument because it secures a regular payment from the tenant, thus creating a secured long-term debt.
Mortgages
Mortgages are a type of debt instrument used to purchase either a home, commercial property, or vacant land. The loan is secured by the property being purchased (which the lender can seize if the borrower defaults on the loan).
As with many other consumer loan products, mortgages are amortized, meaning the borrower makes a series of equal monthly payments that provides the lender with an interest payment (based on the unpaid principal balance as of the beginning of the month) and a principal payment that will cause the unpaid principal balance to decrease each month so that the principal balance will be zero at the time of the final payment.
When seeking a mortgage, it’s important to shop around and compare mortgage rates. While most lenders base their rates on the going prime rate, some are cheaper to work with than others because of additional costs such as origination and processing fees.
Recommended: Mezzanine Financing
Pros and Cons of Debt Instruments
Debt instruments can be mutually beneficial in that both parties become better off as a result. If a company takes out a small business loan and invests those funds wisely, for example, it can increase its profitability. Ideally, the increase in profits exceeds the cost of the loan, a concept known as leveraging in business. Borrowing money also allows a company to raise capital without losing equity.
Debt instruments also benefit individuals and governments. Without mortgage debt, many people would never be able to buy a house or afford to go to college because of the cost. For governments, debt instruments allow them to build infrastructure for the public good.
On the lender’s or investor’s side, debt instruments can provide a regular and guaranteed source of income and are considered a safe investment, provided the loan is secured.
But there are downsides to debt instruments, as well. Loans often come with restrictions on how they can be used and, if you don’t have good credit, interest rates can be high. Borrowing money also involves risk. Most commercial institutions will require you to put up collateral in the form of a property asset. If you lose your income or your business hits hard times and you cannot repay your loan, the lender can reclaim its debt by liquidating whatever you proposed as security, which means you can lose a valuable asset.
On the lender’s or investor’s side, debt instruments also come with risk. Unless you purchase a secured bond, you may not receive your principal back as the investor. Also, during periods of high inflation, bonds can actually have a negative rate of return. And, if you invest in corporate bonds, there is always the possibility that the issuer will default on payment.
| Pros of Debt Instruments | Cons of Debt Instruments |
|---|---|
| Allows companies to expedite their growth | If a borrower has poor credit, interest rates can be high |
| Allows companies to raise capital without diluting equity | Loans often come with restrictions on how they can be used |
| Enables individuals to buy a home or pay for college | Loans often require collateral, which can be lost if debtor defaults on loan |
| For lenders/investors, secured debt is a safe investment | Investors can lose money if bond value declines |
| For lenders/investors, debt instruments provide steady income | Bond investors can lose money during periods of high Inflation |
The Takeaway
A debt instrument is a way for an investor to get a return on their money by loaning to either an individual, business, municipality, or the U.S. government. If you have a credit card or mortgage, or you own any bonds or treasuries in your investment portfolio, debt instruments play a role in your life.
Small business owners can also take advantage of debt instruments. You might not be able to issue corporate bonds at this stage of the game, but you may be able to access an affordable small business loan.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
FAQ
What are some examples of debt instruments?
Common examples of debt instruments include: personal loans, business loans, mortgages, leases, bonds, treasuries, promissory notes, and debentures.
What is the difference between a debt instrument and an equity?
With a debt instrument, the investor does not own any portion of the company. With equity, the investor is buying a portion of the company.
What are the features of debt instruments?
Debt instruments have three characteristics: principal, coupon rate, and maturity. Principal refers to the amount that is borrowed. The coupon rate is the interest amount paid by the borrower to the lender. Maturity is the end date of the debt instrument. It refers to when the debt is completely paid off with interest.
Photo credit: iStock/insta_photos
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOSB0424050