We’ve all been in debt in some way or another. If you’ve purchased a home or a car, you likely didn’t pay for it upfront. Instead, you put some money down and took out a loan to complete the purchase. The loan is a debt instrument.
Let’s look at the many different types of debt instruments and their similarities and differences.
What is a debt instrument?
A debt instrument is a financial tool used to raise capital or generate investment income. Any vehicle classified as ‘debt’—money owed or due—can be labeled a debt instrument.
Debt instruments are assets that require a fixed payment to the holder, usually with interest. The debtor is legally obligated to pay the lender interest and principal payments. They can also be secured by collateral and typically have a time frame to maturity (if there is a maturity date).
All of this is defined according to the contractual terms. The contract of a debt instrument will include the following:
- Interest rate
- Payment schedule
- Maturity date (if applicable)
- Collateral (if applicable)
Let’s take a credit card, for example. When you apply for a credit card and get approved, you receive information about payment deadlines, spending limits, and interest rates. You sign a contract promising to follow the terms and conditions, and you’re good to go. Other types of debt instruments include bonds, leases, and promissory notes.
What is a debt security?
Debt security and debt instruments are often used interchangeably, but they shouldn’t be! Think of debt securities as one step further—they are a more complex form of debt instruments. In this scenario, the borrower can raise money from multiple lenders.
Debt instruments vs equity market
As you now know, debt instruments are assets that require a fixed payment to the holder. The equity market is often referred to as the stock market, and it’s used for trading equity instruments. Equity, or stock, represents a share of ownership of a company. Unlike stocks, with a debt instrument, even if a company is liquidated, bondholders are the first to be paid.
Put simply, debt market = debt instruments, and equity market = equity instruments.
6 common types of debt instruments
There are many different types of debt instruments; here are 6 of the most common.
1. Government or Corporate Bonds
Bonds are issued by the government or corporations when they need to raise money. Bonds are created through a specific contract called bond indenture and are fixed-income investments that are contractually obligated to provide a series of fixed amount interest payments.
The investor pays the issuer the market values of the bond in exchange for a contractual loan repayment and interest rate (coupon) payments. Bonds have a maturity date that requires the principal amount to be repaid in full.
But what if you purchase a corporate bond and the company later declares bankruptcy? Not to worry—bondholders are entitled to repayment of their investments from the company’s assets.
Within a lease, the tenant agrees to pay the owner of the property a set amount of money each month for housing. It falls under the definition of debt instrument because it secures a regular, scheduled rent payment, which is secured long-term debt.
3. Promissory Notes
A promissory note is a signed “promise” to repay a certain amount of money in exchange for a loan or other financing. It will define everything, including the principal debt amount. Interest rate, maturity date, and payment schedule. It’s considered less formal than a loan agreement but is still legally enforceable.
4. Certificates of Deposit
A certificate of deposit, or CD, is a type of savings product offered by banks and other financial institutions that earn interest on a lump sum for a specified period of time. CDs are not the same thing as traditional savings accounts because, with a CD, the money cannot be withdrawn for the entirety of the agreed-upon term. If the money is withdrawn, you will face fees or loss of interest.
The Federal Deposit Insurance Corporation insures standard certificates of deposit for up to $250,000 per depositor per bank, so they are considered to have minimal risk.
A mortgage is a loan secured by a piece of real estate, whether it be a home, land, or commercial property. Mortgages are amortized, which means that the borrower makes a series of monthly payments until the loan is repaid.
If, over time, the borrower can’t pay the loan, the lender will seize the property and begin foreclosure proceedings. This means the lender will regain possession of the property and sell it off to pay the loan.
6. Credit cards
You are likely most familiar with credit cards as a debt instrument. A credit card gives the borrower a set credit limit to use each month for bills and expenses. As you pay your credit card bills on time, your credit limit will increase.
With a credit card, borrowers have two types of payment options:
- Pay the balance in full each month
- Pay the minimum monthly payment
If you opt to pay only the minimum payment, you will be charged interest and the remaining balance will be carried over to the following month. Credit card interest rates are astronomical, so keep that in mind when deciding how to pay it off.
Hedgehog as a debt instrument
Our model at Hedgehog Investments also falls under the debt instrument category. Every Hedgehog investor is considered a lender because the agreement is a loan contract. The contract defines the capital, agreed-upon interest rate, and maturity date.
This material is intended for informational purposes only and should not be construed as legal or tax advice. Information here is not intended to replace the advice of your investment advisor or financial advisor. This information is not an offer or a solicitation to buy or sell securities. This information may have been compiled from third-party sources and is believed to be reliable. All investing involves risk, including the loss of principal.