Credit

Updated on April 4, 2024
Article byKhalid Ahmed
Edited byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

Credit Meaning

Credit refers to a mutual agreement between the lender and the borrower to extend a certain sum of money to the borrower. The lender extends it with or without collateral, for a certain time. Then, they charge a certain interest rate on the outstanding balance as per the agreement. Using credit, customers fulfill their needs without paying in full for a product, house, or education fees, but its default can become a blockade to all new loans.

Credit Definition

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The borrower’s credit repayment ability and credit history help the lender decide on the approval of a loan to the borrower. In addition, lenders use creditworthiness to prepare borrowers’ credit rating models. Also, individuals, firms or organizations cannot start large-scale projects without bank credit

Key Takeaways

  • Credit is a financial agreement between the lender and borrower regarding funds for a project at a certain interest rate to be repaid within a certain duration by the borrower.
  • Credit bureaus use it to measure a borrower’s creditworthiness, which helps the lender decide whether to approve a loan or not to a borrower.
  • The credit bureaus use loan rating models like FICO to generate a three-digit score between 300 and 800, where 740-799 is the best score to avail of loans easily.
  • There are three types of loans – open, revolving, and installments. All three loans are important for – borrowers in getting loans, rented premises, and student loans, and lenders and landlords use them to secure their loans.

Credit Explained

Credit is an agreement between two parties, i.e., the lender and the borrower, regarding a sum of money extended to the debtor as a loan. The borrower must repay the loan creditors lend at an agreed interest rate at a specified time. On a company’s/firm’s balance sheet its entry either decreases assets or increases liability. If a borrower repays all his loans in time and closes the loan account, he has good creditworthiness or a high credit rating. However, if borrowers default on loan repayment, they have to risk financial or legal penalties. Also, their creditworthiness dips or credit rating decreases for every future loan. This practice has been going on since the beginning of human civilization.

The ability to repay loans builds a borrower’s credit history positively, or his creditworthiness increases. However, if the borrower has bad records for repayment of the loan or does not pay his loan on time, then he has bad credit or his creditworthiness is low. Credit rating agencies like Equifax, Experian, or TransUnion use a borrower’s creditworthiness to rate the borrowers’ credit power. All these rating agencies collect the relevant information from the lenders and credit card issuing agencies and then provide the information to the prospective lender or employee, or landlord for their purpose.

The bureaus provide the loan information in the form of credit ratings with all the details of the past loan, repayment history, loan amounts and limits, installments, default in repayment if any, and inquiries for new loans in the past two years.

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Credit Ratings

After the companies prepare the loan ratings, the lenders use them to generate credit scores using the credit score model of either FICO or Vantage Score. They use it to generate a three-digit score ranging from 300 to 850. The scores segregate the customer’s creditworthiness as good, very good, and excellent. Anyone can get their credit score free of cost from credit karma.

Any score between 580-669 is taken as good. A score between 670-739 is considered very good, and a score between 740-799 is considered excellent. Furthermore, the lending institutions refer to each borrower’s credit scores and decide upon the sanctioning of loans as per their internal policy. Moreover, lenders consider borrowers between the score of 740-799 to be the most trustworthy to get any loan when the person applies.

Universal credit is a social security payment scheme for the weak in the United Kingdom. 

Credit Agricole is not a loan rating agency but a project financing bank in France.

Types Of Credit

Credit is a written agreement between lender and borrower containing terms and conditions and a schedule of repayment of loans as per the duration agreed upon by both parties. Hence, it takes many forms like housing, vehicle, credit cards, student, and personal. However, one can club and divide all the different forms of loans into three main loan types: installment loans, open loans, and revolving loans. These three have different structures and repayment schedules for the borrowers.

#1 – Installment-Based Loan 

This type of loan is a loan agreement between the borrower and the lender where the borrower gets the total loan amount in one time which has to be paid in equal monthly installments for a scheduled time as per the agreement. It has two parts the principal amount and the interest amount that decreases as one repays the loan. After the borrower completely pays the loan, the loan is considered closed. Best examples of such loans are mortgage loans, housing loans, vehicle loans, personal loans, and education or student loan.

#2 – Open Loan 

It is mainly related to gas, cable, mobile & telephony services, and electricity bills. An open loan means the consumers of the utility services have to pay the bill in full every month by borrowing the maximum limit for the said period. One example would be the post-paid mobile bill with a monthly maximum limit of borrowing, and after the end of every month, the user of the services has to pay back the bill in full.

#3 – Revolving Loan

This type of loan gives a maximum limit loan for borrowings or spending beyond which one has to pay certain fees and is not allowed to spend above that limit. Credit cards for individuals and lines of credit for businesses work on the same principles. Under this type of loan, the borrower can spend up to the limit and then repays a small portion of the loan amount, replenish the loan account with the same amount and then again borrow funds in a revolving manner. The revolving loan is either unsecured or secured with collateral. Every month, the outstanding interest on the balance has to be paid by the borrower. Home equity line of credit (HELOC) comes under this type of loan.

Examples

Example #1

An example of installment would include a car or automobile loan. 

If a car costs $45,000 and the borrower cannot make a one-time complete payment for the car, s/he can make a down payment and then borrow a loan. This loan is in installments where the buyer must pay a monthly installment. For example, if the monthly installment is $1,000, the buyer must pay that amount for around 40 months. The installment will include the principal amount plus the interest rate.

Example #2

An open credit example would include utility bills like electricity, telephones, internet data, and water bills. 

Let’s take electricity bills. A business or an individual can use electricity for various purposes like running the air conditioner, watching television, charging the laptop, running the washing machine, lighting the lamps, using a vacuum cleaner, and for many other households or office work. The consumers do not have to pay for the electricity separately after using it for a specific service but have to pay the electricity bill together at the end of the month. In addition, they have to pay additional charges for extra usage.

Example #3

Example of revolving credits includes credit cards, home equity, and personal lines of credit. 

Person A can use credit cards to pay for unexpected spending or make daily life purchases. The person can have set dollar limits that can be as low as $300. Along with loan worthiness, the person’s limits depend on age and working status. It requires the person to pay back the loans borrowed. S/he has to pay $50 to $700 depending on the card services usage.

Example #4

Here is a real-life example to understand the concept better.

Credit has been tightening since July 2022 because the Federal Reserve is aggressively hiking the interest rates. According to the data, if the credit dries up, it may create a negative impact and a recession in the United States. The inverted treasury yield curve is one of the three signs. That means the long-term yields are less than the short-term yields. It will curtail banks’ credit availability by negatively affecting their net interest margins.

If the Fed continues to increase its interest rates even after prominent recession signs, the curve will invest further continuously. This inversion will destroy banks’ interest margins. As a result, to preserve capital, banks will restrict credit. 

Why Is Credit Important? 

Credit is an important aspect of today’s generation that has the widest application in every sphere of life. The loan helps in securing finance for undertaking big personal and business projects. It is important because:

  • Lenders decide upon the loan application based on a good loan report. 
  • A good loan record can lead to a lower rate of interest and processing fees on loans.
  • Even prospective employers use the loan record of job applicants to screen the candidates based on their rating status.
  • The landlords are also using the credit record to ascertain their renter’s credibility to decide whether to keep the renter or not.
  • Many institutions decide upon student loan eligibility before sanctioning such loans.
  • Insurance companies review individuals’ loan history while processing insurance coverage for homes or vehicles.
  • The loan lenders also screen business owners for ratings before approving any business loan or loan limit.
  • The most important usage of creditworthiness is the granting of the CC by financial institutions that provide these to customers with the best loan record.

Frequently Asked Questions (FAQs)

What credit score is good?

The credit rating score is different as per different rating models. However, one normally regards a good credit score in the 580-669 range. One regards a score of 670-739 as very good and a score between 740-799 as excellent.

Which credit card is the best?

The credit card offers the best welcome bonus, applicable for a customer with a good rating between 700-749, balance transfer, 0% APR, travel, and airlines. It also offers rewards, cash back earning on a multitude of services, and zero annual fees, which is said to be the best for the consumers. It is so because the advantages are far more. 

What credit score is needed to buy a house?

As per many companies like Experian, the minimum credit score required to apply for and avail a loan for buying a house is a minimum of 620. However, for securing government-backed loans like an FHA loan, a score of 580 is required; for availing a VA loan, a score of 580is required; for a USDA loan, a score of 640 is required.

How is credit score calculated?

One can calculate the credit score as follows:
● History of loan repayment
● Amount of outstanding loan
● Duration of loan
● A mix of loans and
● New loan

This article has been a guide to What is Credit and its Meaning. Here we discuss credit rating and why it’s important along with types and examples. You can learn more from the following articles –

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