Credit (finance) - AbsoluteAstronomy.com

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

Debt

A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...

), 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

Loan

A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....

), or they may consist of goods or services

Goods and services

In economics, economic output is divided into physical goods and intangible services. Consumption of goods and services is assumed to produce utility. It is often used when referring to a Goods and Services Tax....

(e.g. consumer credit). Credit encompasses any form of deferred payment. Credit is extended by a creditor

Creditor

A creditor is a party that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property or...

, also known as a lender, to a debtor

Debtor

A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...

, also known as a borrower.

Credit does not necessarily require money

Money

Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

. 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

Unit of account

A unit of account is a standard monetary unit of measurement of value/cost of goods, services, or assets. It is one of three well-known functions of money. It lends meaning to profits, losses, liability, or assets....

. Unlike money, credit itself cannot act as a unit of account.

Movements of financial capital

Financial capital

Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....

are normally dependent on either credit or equity

Stock

The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

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 market

Financial market

In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...

s. The purest form is the credit default swap

Credit default swap

A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...

market, which is essentially a traded market in credit insurance. A credit default swap represents the price at which two parties exchange this risk

Risk

Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...

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

Bond (finance)

In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

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

The word credit is used in commercial trade

Trade

Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...

in the term "trade credit

Trade credit

Trade credit is an arrangement between businesses to buy goods or services on account, that is, without making immediate cash payment. The supplier typically provides the customer with an agreement to bill them later, stipulating a fixed number of days or other date by which the customer should pay...

" to refer to the approval for delayed payments for purchased goods. Credit is sometimes not granted to a person who has financial instability or difficulty. Companies frequently offer credit to their customers as part of the terms of a purchase agreement. Organizations that offer credit to their customers frequently employ a credit manager

Credit manager

A credit manager is a person employed by an organization to manage the credit department and make decisions concerning credit limits, acceptable levels of risk and terms of payment to their customers. In companies, the role of Credit manager is variable in its scope...

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 card

Credit card

A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...

s, store cards, motor (auto) finance, personal loans (installment loan

Installment credit

Installment credit is a type of credit that has a fixed number of payments, in contrast to revolving credit.-Examples:* Land loan* Home construction loan* Home mortgage* Some equity loans* Home improvement loan* Automobile loan...

s), consumer lines of credit

Line of credit

A line of credit is any credit source extended to a government, business or individual by a bank or other financial institution. A line of credit may take several forms, such as overdraft protection, demand loan, special purpose, export packing credit, term loan, discounting, purchase of...

, retail loans (retail installment loans) and mortgages

Mortgage loan

A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...

. 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

Interest

Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....

, 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

Credit insurance

Credit insurance is a term used to describe both business credit insurance and consumer credit insurance, e.g., credit life insurance, credit disability insurance Credit insurance is a term used to describe both business credit insurance (a.k.a. trade credit insurance) and consumer credit...

, 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

Annual percentage rate

The term annual percentage rate , also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year , rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual 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).

Trade credit

Consumer credit

See also