Debt, Credit, the Cost of Buying Money

What Is Debt?

Debt refers to money that has been borrowed and must be repaid. For example, when you use a credit card, the amount you spend becomes your debt.

What Is Credit?

Credit refers to the ability to borrow money. It's a financial resource you can access when needed, often through a credit card or a loan.

How Does Credit Work?

When using credit, such as a loan or using a credit card, you agree to certain costs and rules. The cost is interest, the fee you pay for borrowing money. The rules include how much money you can borrow, how much interest needs to be repaid, and what happens if you don't repay. The specifics of these rules depend on "creditworthiness," credit score. 

Example:

Using credit (renting money) is like renting a car. You use it for a while, return it in good condition, and pay a fee for the privilege.

Credit Cost Differs for Different People.

Individuals and organizations considered more likely to pay debt back, pay less for their credit. The cost and limit of credit depends on creditworthiness, measured by credit score.

• High credit score: Perceived as more likely to repay debts. Lower interest rates and higher credit limits. Your debt grows slowly.

• Low credit score: Those assigned lower credit score struggle to access leverage (debt). They are only allowed to hold small amounts of debt at high prices. 

Credit and Debt for Governments

These concepts apply to a government's finances as well as personal finances. Governments use debt to pay for everything from large infrastructure projects to everyday office expenses. While individuals typically use banks to access credit and loans, governments sell debt in bond markets. 

How Government Bonds Work

Investors buy these bonds, giving the government cash now. In return, the government promises to pay back the original amount plus interest over time.

• Example:
  A government sells a $100 5-year bond. They agree to pay the buyer $2 each month for 5 years. Eventually, the investor gets $120 back over five years ($100 principal + $20 interest).

When investors believe in a government's financial stability and trustworthiness, it can borrow at lower interest rates. But when there are doubts about a government’s finances or economic outlook, investors demand higher interest rates, or yields, to compensate for the risk of non-repayment.

Real-World Example

On Wednesday, May 21st, Japan experienced its worst bond auction in decades. Investors demanded a record-high yield of 3.2% on 30-year bonds. This means it has become more expensive for Japan to borrow money, highlighting how perceived creditworthiness affects borrowing costs for countries as well as individuals.