Credit is a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at some later date with consideration, generally with interest. It also refers to an accounting entry that either decreases assets or increases liabilities and equity on the company’s balance sheet. Additionally, on the company’s income statement, a debit reduces net income, while a credit increases net income. It also refers to the creditworthiness or history of an individual or company.
It 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, it 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. Credit encompasses any form of deferred payment. It is extended by a creditor, also known as a lender, to a debtor, also known as a borrower.
Bank Issued Credit
The traditional view of banks as intermediaries between savers and borrower is incorrect. Modern banking is about credit creation. It is made up of two parts, the money and its corresponding debt, which requires repayment with interest.
When a bank does this, it effectively owes the money to itself. When a bank issues too much it becomes 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 to do this – 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.
There are two main forms of private credit created by banks; unsecured (non-collateralized) such as consumer credit cards and small unsecured loans, and secured (collateralized), typically secured against the item being purchased with the money (house, boat, car, etc.). To reduce their exposure to the risk of default, banks will tend to issue large sums to those deemed 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 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. It is also traded in financial markets. The purest form is the default swap market, which is essentially a traded market in credit insurance. A default swap represents the price at which two parties exchange this risk – the protection seller takes the risk of default 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).
In commercial trade, the term trade credit refers to the approval of delayed payment for purchased goods. It is sometimes not granted to a buyer who has financial instability or difficulty. Companies frequently offer it to their customers as part of the terms of a purchase agreement.
Why Your Credit Report Is Important
A variety of businesses check your report to make decisions about you. Banks check your report before approving you for credit cards and loans, including a mortgage or auto loan.
Landlords review your report to decide whether to rent to you. Some employers check reports as part of the application process. Your report affects many parts of your life, so it’s important that the information included is accurate and positive.
Your report is the sole source of information for your score, a number that lenders sometimes use instead of or in addition to your report. A credit score is a three-digit number that helps rate your report. High scores show that you have positive information on your report while low scores indicate the presence of negative information.
Contrary to popular belief, when applying for corporate finance, credit is not the determining factor.
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