What it is:
How it works (Example):
There are generally two types of creditors: personal and real. Personal creditors are people who loan money to friends or family. Real creditors are financial entities who require borrowers to sign legal contracts that grant the creditor some sort of collateral -- e.g. car, house, jewelry -- if the borrower fails to repay the loan.
Let's look at a scenario with a real creditor, XYZ Bank, to whom you go to for a loan. If you are approved and they lend you money, XYZ Bank becomes your creditor.
Individuals and companies can have several creditors at any given time, for many different types of debt. Additional examples of creditors who extend credit lines of money or services include: utility companies, health clubs, phone companies and credit card issuers.
Not all creditors are considered equal. Some creditors are considered superior to others (senior), while others are subordinate.
For example, if Company XYZ issues bonds, the bondholders become creditors senior to Company XYZ's shareholders. And should Company XYZ then go bankrupt, the senior bondholders are entitled to repayment before the shareholders are.
Why it Matters:
If a borrower does not repay the credit, creditors have the legal right to:
- Sue to obtain access to accounts or other assets if the borrower has not paid.
- Place liens on the borrower's assets. This means the borrower cannot sell the assets without paying the creditor first.
The distinction between senior debt and subordinated debt is crucial for creditors and investors. Senior debt is considered less risky than subordinated debt because it is first in line to be repaid once means for repayment have become available. That means that the interest rate paid on senior debt is lower than that paid on unsecured debt.