Debt Study Guide

📖 Core Concepts Debt – A contractual obligation to pay back borrowed money (principal) plus any required interest. Principal – The original amount borrowed; the base on which interest is calculated. Interest – Cost of borrowing, expressed as a % of principal per time period. Secured vs. Unsecured Debt – Secured debt is backed by specific collateral (e.g., house, car); unsecured debt has no claim on assets. Amortization – Gradual repayment of principal (plus interest) over the loan term. Bullet Loan – Only interest is paid during the term; the entire principal is repaid in one “balloon” payment at maturity. Creditworthiness Metrics – Debt‑service‑coverage ratio (DSCR), debt‑to‑income (DTI) ratios, loan‑to‑value (LTV) ratio, and credit ratings. --- 📌 Must Remember DSCR = Income Available ÷ Debt Service Due → > 1.0 = able to cover payments. Front‑end (mortgage) ratio ≤ 28 % ; Back‑end (total debt) ratio ≤ 36 % for most conforming loans. LTV = Loan Amount ÷ Collateral Value → 80 % LTV → 20 % down payment. Junk‑bond threshold – Ratings below Baa/BBB (Moody’s/ S&P) indicate high default risk and higher yields. Treasury securities = benchmark “risk‑free” rate; maturities range 1 day – 30 years. Securitization = Pool assets → trust → issue securities to investors. --- 🔄 Key Processes Loan Amortization Compute monthly payment using amortization formula. Apply each payment: interest = remaining principal × periodic rate; principal = payment – interest; update balance. Bullet Loan Repayment Pay periodic interest only. At maturity, pay full principal (balloon). Credit Assessment (mortgage) Calculate front‑end ratio → mortgage + insurance + taxes ÷ monthly income. Calculate back‑end ratio → total debt payments ÷ monthly income. Verify DSCR if income‑based financing (e.g., revenue‑based loans). Securitization Flow Originator sells asset pool → special purpose vehicle (trust). Trust issues asset‑backed securities → investors receive cash flows from pool. Rating Assignment (Moody’s) Evaluate credit risk → assign letter grade (Aaa‑C) + numeric modifier (1‑3). --- 🔍 Key Comparisons Amortized Loan vs. Bullet Loan Amortized: principal repaid gradually; lower balloon risk. Bullet: single large principal payment at end; higher refinancing risk. Secured Debt vs. Unsecured Debt Secured: collateral reduces lender risk → lower interest rates. Unsecured: no collateral → higher rates, possible personal guarantee. Debt‑to‑Value (LTV) vs. Debt‑to‑Income (DTI) LTV: measures loan size relative to asset value (collateral focus). DTI: measures borrower’s cash‑flow capacity (income focus). Junk Bond vs. Investment‑Grade Bond Junk: rating < Baa/BBB, higher yield, higher default risk. Investment‑Grade: rating ≥ Baa/BBB, lower yield, lower risk. --- ⚠️ Common Misunderstandings “Interest rate = cost of debt” – Forgetting that effective cost also includes fees, compounding frequency, and tax effects. “All debt is bad” – Ignoring the tax deductibility of interest and the leverage benefits for firms. “Higher LTV always means higher risk” – Risk also depends on borrower cash flow, credit score, and collateral quality. “Bullet loan = no interest risk” – Interest‑rate risk remains; if rates rise, refinancing the balloon can be costly. --- 🧠 Mental Models / Intuition “Debt as a lever” – Think of debt as a lever that magnifies returns (or losses). The longer the lever (higher leverage), the more sensitive you are to changes in earnings or asset values. “Collateral is a safety net” – The stronger the net (higher‑value asset, lower LTV), the lower the lender’s perceived risk → lower interest. “Ratios are traffic lights” – DSCR > 1.2 = green (safe), 1.0‑1.2 = yellow (caution), < 1.0 = red (danger). --- 🚩 Exceptions & Edge Cases Revenue‑based financing – Repayment is a % of revenue, not fixed; DSCR can fluctuate wildly month‑to‑month. Syndicated loans – Individual lender exposure is limited, but covenant breaches affect the whole syndicate. Zero‑coupon bonds – No periodic coupons; interest accrues and is paid at maturity (similar to bullet loan). --- 📍 When to Use Which Choose amortization when you need predictable cash flow and want to avoid large end‑term refinancing risk (e.g., residential mortgages). Choose bullet loan for short‑term projects with expected cash windfall at maturity (e.g., construction financing). Use LTV to evaluate asset‑backed loans; use DTI/DSCR for income‑based lending (mortgages, revenue‑based financing). Select secured debt when you have valuable collateral and want lower rates; use unsecured if collateral is unavailable or you prefer flexibility. --- 👀 Patterns to Recognize “High LTV + Low DSCR” → red flag for lenders (high asset leverage + weak cash flow). “Rating drop + widening spread” → market expects higher default risk → bond price falls. “Bullet loan + near‑term maturity” → watch for refinancing risk in the next 12‑24 months. “Securitization → tranches” – senior tranches have lower yields, junior tranches absorb first losses. --- 🗂️ Exam Traps Confusing LTV with DTI – LTV uses collateral value; DTI uses borrower income. Assuming all “junk” bonds have the same yield – Yield varies with specific issuer risk and market conditions. Thinking a “secured” loan always has lower interest – Rate also depends on borrower credit quality and market rates. Misreading DSCR – A ratio of 0.9 does not mean you can cover 90 % of payments; it indicates a shortfall. Overlooking balloon payment – Bullet loans often hide the large final principal due; exam questions may ask for total cash outlay at maturity. ---