Credit

Domestic credit to private sector in 2005

Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately (thereby generating a debt), but instead arranges either to repay or return those resources (or other materials of equal value) at a later date. 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.

Credit does not necessarily require money. The credit concept can be applied in barter economies as well, based on the direct exchange of goods and services (Ingham 2004 p.12-19). However, in modern societies credit is usually denominated by a unit of account. Unlike money, credit itself cannot act as a unit of account.

Movements of financial capital are normally dependent on either credit or equity transfers. 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 par amount (that is, is made whole).

Trade credit

An arrangement to buy goods or services on account, that is, without making immediate cash payment 

For many businesses, trade credit is an essential tool for financing growth. Trade credit is the credit extended to you by suppliers who let you buy now and pay later. Any time you take delivery of materials, equipment or other valuables without paying cash on the spot, you're using trade credit.

When you're first starting your business, however, suppliers most likely aren't going to offer you trade credit. They're going to want to make every order c.o.d. (cash or check on delivery) or paid by credit card in advance until you've established that you can pay your bills on time. While this is a fairly normal practice, you can still try and negotiate trade credit with suppliers. One of the things that will help you in these negotiations is a properly prepared financial plan.

When you visit your supplier to set up your order during your startup period, ask to speak directly to the owner of the business if it's a small company. If it's a larger business, ask to speak to the CFO or any other person who approves credit. Introduce yourself. Show the officer the financial plan you've prepared. Tell the owner or financial officer about your business, and explain that you need to get your first orders on credit in order to launch your venture.

Depending on the terms available from your suppliers, the cost of trade credit can be quite high. For example, assume you make a purchase from a supplier who decides to extend credit to you. The terms the supplier offers you are two-percent cash discount with 10 days and a net date of 30 days. Essentially, the suppliers is saying that if you pay within 10 days, the purchase price will be discounted by two percent. On the other hand, by forfeiting the two-percent discount, you're able to use your money for 20 more days. On an annualized basis, this is actually costing you 36 percent of the total cost of the items you are purchasing from this supplier! (360 ( 20 days = 18 times per year without discount; 18 ( 2 percent discount = 36 percent discount missed.)

Cash discounts aren't the only factor you have to consider in the equation. There are also late-payment or delinquency penalties should you extend payment beyond the agreed-upon terms. These can usually run between one and two percent on a monthly basis. If you miss your net payment date for an entire year, that can cost you as much as 12 to 24 percent in penalty interest.

Effective use of trade credit requires intelligent planning to avoid unnecessary costs through forfeiture of cash discounts or the incurring of delinquency penalties. But every business should take full advantage of trade that is available without additional cost in order to reduce its need for capital from other sources.

Consumer credit

Consumer debt can be defined as ‘money, goods or services provided to an individual in lieu of payment.’ Common forms of consumer credit include credit cards, store cards, motor (auto) finance, personal loans (installment loans), consumer lines of credit, 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 Federal Reserve in the US.

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 not included in the APR calculation. So if there is a tick box on an application form asking if the consumer would like to take out payment insurance, then insurance costs will not be included in the APR calculation (Finlay 2009).

See also

• Commercial credit reporting
• Credit bureau
• Credit history
• Credit risk
• Credit score
• Debt
• Default (finance)
• Financial literacy
• Installment credit
• Line of credit
• Payday loan
• Person-to-person lending
• Predatory lending
• Revolving credit
• Risk-return spectrum
• Settlement (finance)
• Sub prime lending
• Social Credit

References

• Finlay, S. (2009). Consumer Credit Fundamentals. Second Edition. Palgrave Macmillan.
• Ingham, G. (2004). The Nature of Money. Polity Press.

External links

Quotations related to Credit at Wikiquote