Debtor Meaning
Debtor is a person or any other form of party in a transaction which owes money to the other party. The receiver is called as creditor while the giver is known as the debtor and the payment terms vary for each transaction based on the terms and conditions discussed between the parties.
In case of a mortgage, the Debtor pays interest in exchange for a loan taken from the lender in addition to the principal borrowed.
How to Calculate Oustanding Loan of Debtor?
Case 1
Return of simply borrowed money without interest:
Borrowed Capital = Capital to be Returned
Case 2
Return of simply borrowed money with simple interest
Amount to be Returned (A) = Principal (P) * Rate of interest (R) *Time (T) /100
Case 3
Return of simply borrowed money with compound interest
Amount to be Returned (A) = Principal (P)* [1 + Rate of interest (R)]^(Time (T)
Debtors, in most cases, are required to pay as per compounding rate of interest.
Examples of Debtor
Example #1
Mr. A wishes to buy a car worth $100,000. He can invest $30,000 from his available savings. However, he is falling short of $70,000. He approaches a financial consultant who advises him to opt for a personal loan.
Mr. A visits ABC Bank, which offers him a loan of $70,000 for a term of 5 years to be returned with 10% interest annually. Upon signing up for the loan, Mr. A is known as a “debtor” and bank, which is the other party is called the “creditor.” Once Mr. A is paid out with the loan amount, he approaches the car dealer, pays him the amount of $100,000, and gets the ownership of that car.
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However, as part of the amount is his indebtedness to the bank, he needs to repay it to them based on their credit terms.
As the interest calculation is not mentioned as a compounded basis, it is understood to be simple interest.
- Principal (P): $70,000
- Term (T): 5 years
- Interest rate (R): 10% annually
Therefore, calculation of the amount to be paid at the end of 5 years using below formula is as follows,
Amount to be paid at the end of 5 years (A) = [(P X R X T)] + Principal (P)
- (A) = 70,000 + [(70,000 X 10% X 5)]
- = $105,000
Based on the calculation, the interest portion is $35,000, and the Principal is $70,000.
Example #2
Anna gets into a debt of $20,000 for a period of 2 years at an interest rate of 2% compounded annually. Anna is a debtor in this case. Calculate the amount to be paid at the end of 2 years and total interest paid on this debt.
(Assume Anna pays the installments on an annual basis).
Solution
- Principal (P): $20,000
- Interest Rate (R): 2% annually
- Time (T): 2 years
Therefore, calculation of amount to be paid at end of 2 years using below formula is as follows,
Amount (A) = [P (1 + R) ^ T ]
- (A) = [20,000 ((1 + 2%)^2)]
- = $20,808
Total Interest Paid for this Debt
Total interest paid for this debt = $20,808 – $20,000 = $808.
Advantages
- The amount borrowed can be raised at once. The loan amount (or debt) can be received as once, which is repaid later in installments. In case of urgent requirements, when the Debtor is short of required capital, debt can be raised to suffice immediately.
- Raising a loan is a way to leverage money in markets. Idle money lying with creditors can be put to use to create more money by lending out to debtors. The debt can be based upon agreed terms and conditions between the parties.
Disadvantages
- It is a form of liability. Due to the time value of money, every penny lent costs more in the future than today. Hence there is an interest attached to indebtedness. A debtor always has an element of repayment attached to its finances. Even though the payment may be in smaller installments for future dates, what he pays is more than that availed from the creditor.
- Creditor always keeps their terms and conditions at the time of lending, which has to be followed by the Debtor in order to avail the loan.
- Too much indebtedness reflects negatively on the balance sheet.
- The creditor faces a default risk. The Debtor may default in future payments on the loan. Hence there is a risk involved in such a deal. In most cases, creditors are required to hedge their risk by entering into an offsetting position.
Limitations
- A debtor may or may not be aware of the benefits he can derive from interest rates. Interest rates are very volatile in markets, and once they start fluctuating, the actual returns/payments on security may change largely. However, it is difficult to predict the movement in the future. Hence, they have to go into an agreement for debt as per their view on the market, which may or may not be correct.
- A debtor goes for a debt only case of “need” for money (or the benefit from such debt). Hence, it poses a limitation to them, in the scarcity/absence of which the next procedure cannot be taken up. It may also happen that required for such a debt, and options available can be concluded after a detailed analysis.
Conclusion
From a debtor’s view, Sundry Creditors and Accounts Payables as balance sheet items are added on the liabilities side of the balance sheet, while from a creditor’s view, Sundry Debtors or Accounts Receivable are added on the assets side.
Apart from payment by cash, a deal may require them to make payment in kind apart from the principle on the debt. Such deals are specific, customized, as per the size of the loan and relationship between the creditor and the Debtor. In such cases, payment terms also differ from general loan terms.
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