Meaning and Significance of credit

Recently updated on April 13th, 2023 at 05:58 pm

Credit is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt), but promises either to repay or return those resources (or other materials of equal value) at a later date. In other words, credit is a method of making reciprocity formal, legally enforceable, and extensible to a large group of unrelated people.

The resources provided may be financial (e.g. granting a loan), or they may consist of goods or services (e.g. consumer credit). Credit encompasses any form of deferred payment. Credit is extended by a creditor, also known as a lender, to a debtor, also known as a borrower.

Bank-issued credit

Bank-issued credit makes up the largest proportion of credit in existence. The traditional view of banks as intermediaries between savers and borrowers is incorrect. Modern banking is about credit creation. Credit is made up of two parts, the credit (money) and its corresponding debt, which requires repayment with interest. The majority (97% as of December 2013) of the money in the UK economy is created as credit. When a bank issues credit (i.e. makes a loan), it writes a negative entry in to the liabilities column of its balance sheet, and an equivalent positive figure on the assets column; the asset being the loan repayment income stream (plus interest) from a credit-worthy individual. When the debt is fully repaid, the credit and debt are cancelled, and the money disappears from the economy. Meanwhile, the debtor receives a positive cash balance (which is used to purchase something like a house), but also an equivalent negative liability to be repaid to the bank over the duration. Most of the credit created goes into the purchase of land and property, creating inflation in those markets, which is a major driver of the economic cycle.

When a bank creates credit, it effectively owes the money to itself. If a bank issues too much bad credit (those debtors who are unable to pay it back), the bank will become insolvent; having more liabilities than assets. That the bank never had the money to lend in the first place is immaterial the banking license affords banks to create credit what matters is that a bank’s total assets are greater than its total liabilities and that it is holding sufficient liquid assets – such as cash – to meet its obligations to its debtors. If it fails to do this it risks bankruptcy or banking license withdrawal.

There are two main forms of private credit created by banks; unsecured (non-collateralized) credit such as consumer credit cards and small unsecured loans, and secured (collateralized) credit, typically secured against the item being purchased with the money (house, boat, car, etc.). To reduce their exposure to the risk of not getting their money back (credit default), banks will tend to issue large credit sums to those deemed credit-worthy, and also to require collateral; something of equivalent value to the loan, which will be passed to the bank if the debtor fails to meet the repayment terms of the loan. In this instance, the bank uses the sale of the collateral to reduce its liabilities. Examples of secured credit include consumer mortgages used to buy houses, boats, etc., and PCP (personal contract plan) credit agreements for automobile purchases.

Movements of financial capital are normally dependent on either credit or equity transfers. The global credit market is three times the size of global equity. Credit is in turn dependent on the reputation or creditworthiness of the entity which takes responsibility for the funds. Credit is also traded in financial markets. The purest form is the credit default swap market, which is essentially a traded market in credit insurance. A credit default swap represents the price at which two parties exchange this risk – the protection seller takes the risk of default of the credit in return for a payment, commonly denoted in basis points (one basis point is 1/100 of a percent) of the notional amount to be referenced, while the protection buyer pays this premium and in the case of default of the underlying (a loan, bond or other receivable), delivers this receivable to the protection seller and receives from the seller the paramount (that is, is made whole).

Types

There are many types of credit, including but not limited to bank credit, commerce, consumer credit, investment credit, international credit, and public credit.

Trade credit

In commercial trade, the term “trade credit” refers to the approval of delayed payment for purchased goods. Credit is sometimes not granted to a buyer who has financial instability or difficulty. Companies frequently offer trade credit to their customers as part of terms of a purchase agreement. Organizations that offer credit to their customers frequently employ a credit manager.

Consumer credit

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Consumer credit can be defined as “money, goods or services provided to an individual in the absence of immediate payment”. Common forms of consumer credit include credit cards, store cards, motor vehicle finance, personal loans (installment loans), consumer lines of credit, payday loans, retail loans (retail installment loans) and mortgages. This is a broad definition of consumer credit and corresponds with the Bank of England’s definition of “Lending to individuals”. Given the size and nature of the mortgage market, many observers classify mortgage lending as a separate category of personal borrowing, and consequently, residential mortgages are excluded from some definitions of consumer credit, such as the one adopted by the U.S. Federal Reserve.

The cost of credit is the additional amount, over and above the amount borrowed, that the borrower has to pay. It includes interest, arrangement fees and any other charges. Some costs are mandatory, required by the lender as an integral part of the credit agreement. Other costs, such as those for credit insurance, may be optional; the borrower chooses whether or not they are included as part of the agreement.

Interest and other charges are presented in a variety of different ways, but under many legislative regimes lenders are required to quote all mandatory charges in the form of an annual percentage rate (APR). The goal of the APR calculation is to promote “truth in lending”, to give potential borrowers a clear measure of the true cost of borrowing and to allow a comparison to be made between competing products. The APR is derived from the pattern of advances and repayments made during the agreement. Optional charges are usually not included in the APR calculation.

Revolving Credit

Revolving credit is most often associated with credit cards, but can also apply to lines of credit attached to checking accounts or home equity lines of credit (HELOCs). Revolving credit means the lender assigns you a credit limit which is often based on your creditworthiness. The lender can increase or decrease your credit limit based on factors such as payment history.

As consumers pay down their balance each month, they can make further charges to that credit account up to the limit. If you’re working on building your credit history, it’s a best practice to pay off your balance in full each month, which also prevents you from going into debt.

Installment Credit

Installment credit is a loan for a specific amount of money that the borrower makes payments toward over time. Common types of installment credit include mortgage loans, vehicle loans, student loans, and other personal loans. The interest rates on installment credit are often fixed throughout the life of the loan, unlike interest rates on revolving credit, which can fluctuate.

Service Credit

There is no such thing as a no-risk investment. Investment scammers, however, will do their best to appeal to investors’ desires to make a lot of money without risking their initial investment. Licensed investment brokers are very transparent about the fact that all investments carry inherent risk.

Service credit is different from revolving credit and installment credit in that you’re borrowing money for utility services. Utility companies who provide electric, gas, water, or other services create contracts with you in the understanding that when they provide services, you’ll pay for those services at the end of the month after you’ve used them. This is why the payment history on your utility bills is included in your credit reports.

Interest rates on loans to consumers, whether mortgages or credit cards are most commonly determined with reference to a credit score. Calculated by private credit rating agencies or centralized credit bureaus based on factors such as prior defaults, payment history, and available credit, individuals with higher credit scores have access to lower APRs than those with lower scores.

Importance of Credit for Country

  • The economic needs of agricultural, commercial and industrial sector of the economy are adequately met by the bank credit.
  • Credit enables the individual or business to “purchase ahead of ability” or “desire to pay”.
  • Bank credit accelerates the process of economic development in the country by providing loan to the industries in time.
  • The farm credit needed by farmers helps in increasing agricultural production in the country and helps the farmers in the development of agricultural.
  • Goods are purchased, processed, store and then sold at the appropriate time to consumers.
  • Bank credit facilitates the large scale production of goods and other necessities of life, which result in technological research and lowering the cost.
  • From the bank credit, the transportation of commodities from one place to another place is also made easier and economical.
  • The consumption needs of the consumers such as automobile, house and other necessaries are also met by the commercial credit.
  • Supply of credit by bank to consumers and business, increases the rate of economic growth, which would have been limited with the savings of the people.
  • The rate of interest is also influenced by the bank credit. The flexibility of bank credit regulates the rate of interest which has healthy effects on the production in the economy.
  • Credit instruments, like bill of exchange, greatly facilitate international trade. Payments thus made without the actual movement of treasure to any large extent.
  • With the help of credit, people with brilliant brain can utilize their abilities and qualities in running business enterprises. In the absence of credit, their talents would have gone waste.

Importance of Credit for Business

The value of anything paid at once. But in case of any credit transaction the value is paid after some specific period of time. Thus, it shows the importance of credit for business. However, making payment after some time, this facility is allowed to only trusted persons. Hence credit involves two factors that is “Time” and “Confidence”.

If we work around our world, we will see that almost all the business dealings and other transaction are made on credit basis instead of cash. The credit system is becoming more popular replacing the use of money or cash day by day. In daily affairs, the goods and vehicle are bought and sold in the credit form, which is just a “Promise” to make the payment in “Future”. These payments are made in credit though different kinds of instruments, like cheque, bill of exchange and promissory note, etc. The importance of credit can be seen from the following points for business.

  • Through availability of credit, new business enterprises came into existence using their abilities effectively.
  • Convenience in purchase and sales of goods though credit enables the consumers to purchase ahead of his ability.
  • There can be an economy in the use of metal money by using the credit money. Credit money is more safe and convenient than metal money.
  • With the help of credit, government loan are available. These funds are used for the construction of projects for the use of general public.
  • Now the production is carried on large scales. It is only possible when credit money is also available for over and excess funds for production. This is show the great importance of credit for business.
  • Credit also help in overall production of goods in the country. The producers engaged in different type of production process can avail the facility of credit for their financial requirements.
  • The credit money also helps to keep the prices in a stable position. Increase in money supply though credit increase the output of goods and services.
  • In international trade, the payments are made though bill of exchange, instead of making in cash or gold. This also enhances the importance of credit for business world.
  • Credit also results in improving the living standard of the peoples. When money supplies total increases, income and per capita also increases, then ultimately it leads to a good living standard.
  • If the government is facing a deficit in her expenditure the shortfall can be covered by the sales of bonds. It is only possible though credit system.

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