What is a Debtor?

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Definition:

A debtor is a person or entity that owes money to another party, typically because of a loan.

🤔 Understanding debtors

A debtor is a person or organization that owes money to another entity, usually after taking out a loan. When you borrow money from someone, the lender (also known as the creditor) expects you to repay that debt. Debtors, also known as borrowers, are responsible for making payments on their debts according to agreed-upon terms. Being a debtor isn’t necessarily a bad thing — It’s often essential to making big purchases, like a house or a car. But failing to repay debts on time can hurt borrowers’ credit scores. Creditors may refer the debt to a collection agency or pursue legal action to force them to repay the money. Borrowers who cannot pay their debts might have to declare bankruptcy.

Example

Imagine Jane wants to buy a new car and applies for an auto loan. The bank approves her application and lends her $20,000.

Because Jane borrowed money, she is now a debtor and owes that sum to the bank, with interest. The bank sends monthly bills that she must pay. If Jane fails to make payments, the bank can inform credit reporting agencies, harming her credit score. If she continues not to pay, the bank may be able to sue her.

Takeaway

A debtor is like someone who asks a friend to cover his or her meal…

When your friend fronts the money for your food, there’s usually an expectation that you’ll pay it back or cover one of their meals in the future. When you borrow money from a bank, you also become a debtor. You owe the bank money and need to pay it back. The difference is that there are clear legal consequences if you don’t repay your debt.

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Tell me more…

What is a debtor?

A debtor is any person, company, or other organization that owes money to another party. Typically, people become debtors when they take out a loan or otherwise borrow cash from a person or lender. Another way to become a debtor is to accept a shipment of goods with the promise that you’ll pay the bill at a later date.

Being a debtor isn’t necessarily a bad thing. Debt is an essential part of modern financial life. People often need help making large purchases, such as a home or a car, and debt can help them finance those expenses. Debts secured by valuable assets (like real estate in the case of mortgages) can come with low interest rates, making them relatively cheap. Many people use credit cards for everyday purchases, reaping cash back or travel rewards as a result. Businesses often borrow money to invest in growth or survive tough times.

Debt does come with risks. When you owe someone money, you need to repay it eventually, often with interest. If you don’t make required payments, the lender can add fees and other penalties to your debt, increasing its cost. Some debts, like payday loans or credit card debt, can carry higher fees than others.

Failing to repay debt on time, or taking out too much relative to your income, can damage your credit score, making it harder for you to borrow money or even rent an apartment in the future. Not paying for an extended time period can also lead to collection agencies coming after you for payment.

In the worst case, lenders can sue debtors to try and compel them to pay their debts. This can result in wage garnishment or other court-ordered payments.

What is the difference between a debtor and a creditor?

The difference between a creditor and debtor is which side of a loan each party falls on.

A debtor is a person or company that borrows money. A creditor is the one that lends the money to the debtor.

Typically, financial institutions like banks and credit card companies serve as creditors for people who want to borrow money.

The same person or company can be both a debtor and a creditor. If you get a mortgage to buy a home, you become a debtor to your bank. At the same time, you can lend a few dollars to your friend, making you a creditor.

How do companies report debts on financial statements?

Businesses report both their debts and the money others owe them on financial statements.

Debtors report loan balances on their balance sheets as a liability. Typical short-term debts include things like:

  • Accounts payable (payments owed to suppliers)
  • Money owed to employees
  • Short-term notes (like a bond to be paid within the next year)
  • Deferred revenue (payment received for products the business hasn’t shipped yet)
  • Current payments owed on long-term debts (due in the next year)

Long-term debts include:

  • Long-term borrowing, such as mortgages
  • Bonds payable (principal and interest owed on all bonds the company has issued)
  • Deferred compensation, such as retirement plan contributions, pension payments, or options
  • Long-term lease payments

Creditors also report the money that others owe them as assets on their balance sheets. Some examples include:

  • Accounts receivable (payments owed by the company’s customers)
  • Short-term notes receivable (payments due from the company’s short-term borrowers in the next year)
  • Prepaid expenses (payments made for goods not yet received)

What is a debtor in the eyes of the law?

Legally, a debtor is a party that owes money to a creditor. Debtors can have three types of relationships with their creditors, which determine the order in which borrowers must pay them if they are unable to handle all their debts:

  1. A creditor who has a lien against (legal right to repossess) one or more of the debtor’s assets gets compensated first. In this scenario, if the debtor can’t make payments, he or she must give the assets to the creditor or sell them to settle the debt. A typical example of this is a mortgage. The creditor has a lien against the property the debtor purchased with the loan. Creditors who hold liens have first dibs on payments when a debtor becomes insolvent.
  2. If a debtor must sell assets to satisfy debts, creditors with priority interest get paid before others. However, creditors who have a lien on the debtor’s assets can claim them (or cash from their sale) before priority creditors receive payment.
  3. Creditors who have neither a lien nor priority over other creditors are last in line for payment if the borrower declares bankruptcy.

The law treats each relationship differently, and each state can set its own rules regarding liens and priority creditors.

Can debtors go to jail for unpaid debts?

There are only two types of unpaid debts that can send someone to jail in certain situations: tax debt and child support obligations. Failure to pay either can lead to jail sentences that vary with local laws.

You cannot go to prison for failing to pay other types of debts. Debtor’s prisons were common in the past but no longer exist in the US today.

Failure to pay your debts does have other consequences. For one, most creditors report your payment history to the major credit bureaus. When you apply for a loan, almost any lender will check your credit history, so missing payments on your debts make it harder to borrow money in the future or get good terms.

Creditors can also sue debtors to try to compel them to make payments. If you lose in court, a judge could order you to pay what you owe or allow the creditor to garnish your wages. If you don’t show up to your court date, you could go to jail for failure to appear.

What are the laws around debtors?

There are many federal and state laws surrounding debtors and how creditors can treat them.

The federal Fair Debt Collection Practices Act (FDCPA) sets guidelines for how debt collectors can treat individuals while pursuing payment.

For example, it bars collectors from contacting debtors before 8 a.m. or after 9 p.m. unless the borrower gives explicit permission. Debtors can also request that collectors not contact them at work or not contact them at all. Or they can require collectors to correspond through an attorney instead.

Debtors have the right to demand proof that they owe the money a debt collector claims they owe. The creditor must provide evidence that the debtor owes the money and the agency has the right to collect.

Debtors also have protection from unfair collection practices. For example, collectors cannot harass debtors by threatening them with physical harm or calling them incessantly. They also cannot lie to borrowers, try to collect more than the debtor owes, or threaten to sue them unless they have the right to do so. Keep in mind that this law applies to debt collection agencies, not all creditors.

What happens if a debtor does not pay?

If a debtor fails to make payments on time, the creditor reports this to credit bureaus after at least 30 days. Credit bureaus make a note of the missed payments on the debtor’s credit report, which hurts his or her credit score. The creditor can also add fees and penalties to the borrower’s balance.

If someone fails to pay for many months, usually at least 180 days, the creditor sends the debt to a collection agency. The agency pays the creditor for the right to collect past-due debts or works on a commission basis. The collections agency pursues payment from the debtor. If the debtor still fails to pay, the agency will either write-off the debt, sell it to another collection agency, or bring the debtor to court.

One important thing to note is that debts have a statute of limitations. Depending on the type of debt and where you live, if you have not made debt payments for more than a few years, collectors may not have the right to pursue payment. The unpaid debt can remain on your credit report and damage your credit score, but collectors can’t make you pay an expired debt.

Bankruptcy is an option for people who cannot repay their debts. It lets debtors discharge their debt or restructure their payments so that they are more easily manageable. The process can take a while and will damage the debtor’s credit score, but can offer long-term relief from debt.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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