What is Credit? Money that is loaned to you by a creditor or lender is called credit. In exchange for the funds you agree to make installment or a lump sum payment at some future date. Usually these terms will include some provision for interest and fees. Creditors can be banks, charge card companies, and merchants who may provide charging privileges. The benefit of this type of financial extension is that it allows you to purchase goods and services before paying for them and it also allows the economy in general to benefit from the increased purchasing power which otherwise might not be there. As long as the borrower can maintain the service or interest payment on the debt, everybody benefits.
Unfortunately, many consumers and companies can get into trouble managing their debt load and end up paying many times over the amount borrowed or default completely on the debt. This type of over leverage is what creditors look for in determining a borrower's risk. Creditor's are always looking for accurate ways of determining the likelihood of repayment and thus reducing losses. A reduction in losses directly affects the interest rate a lender need charge to cover reasonable profit and unrecoverable funds.
There are three kinds of credit: open, revolving, and installment credit.
This type of loan is for accounts that require full repayment each billing cycle for services rendered. An example would be utility bills. You do not pay for the water or electricity you use as you use it but at the end of your billing cycle. In effect, the utility is extending you a loan for the month as you use the services.
This is the most common type of extension and what is usually associated with charge cards most consumers use. Revolving credit allows you to charge purchases up to a predetermined limit. At the end of your billing cycle you are required to make at least a minimum payment or pay the balance in full. The minimum payment is calculated in a variety of ways but usually includes some combination of partial principal and complete interest payment. Any unpaid balance will be carried over the next billing cycle, usually with an interest charge and then the minimum payment is recalculated. Revolving credit lines offer consumers the most flexibility but their terms and conditions vary. Consumers that are considered safe financial risks are offered lower interest rates while moderate and high risk consumers are charged significantly higher. Some examples of include:
- Credit cards
- Overdraft protection
- Home Equity lines of credit
An installment loan refers typically refers to financial obligations that require fixed payment at regular intervals. The number and amount of installment payments are predetermined before the loan is offered. The size of the payments does not change during the term of the loan. Installment obligations are also known as closed-end loans. Examples of installment payments include:
- Student loans
- Auto loans
- Mortgage loans
- Personal loans
The creation and extension of funds has helped our economy grow faster than it otherwise would have and the increased liquidity has financed economic activity in almost all areas. Some critics of the extension of unsecured loans have called it a form of mortgaging our future for the whims of today. Regardless, it's important for the individual consumer to understand that any funds borrowed must be repaid with interest. It's also important to establish a reputation as a borrower by proving to creditors that you can pay back money you've loaned.