What is Credit?
Credit is a promise. A credit transaction occurs when one party, the lender, in lieu of an immediate cash payment, agrees to accept the borrower's promise of future payment according to mutually agreed upon terms.
Who are the Parties Involved?
A credit transaction involves at least two parties:
- The lender provides value in the form of cash, merchandise, or some other item of value.
- The borrower makes a commitment to pay what he or she owes according to a pre-agreed schedule.
What are the Common Types of Credit?
Credit is offered in a variety of ways. The following are three most common types of credit:
- Revolving Credit
- The most common form of revolving credit is the use of credit cards.
- A credit card transaction is simply a loan, which takes place when the cardholder makes a purchase using the card, and the issuer pays the merchant on the cardholder's behalf.
- The cost of using this type of credit varies from card to card, as do the repayment terms.
- Typically, the amount owed does not have to be paid in full each month. However, interest is charged on the unpaid balance.
- Interest is computed on both the principal (amount borrowed and owed from the month before) and any unpaid interest not paid off the previous month.
- Once an amount borrowed has been paid, an equal amount of credit is again made available to borrow. This is the reason that this type of credit is referred to as "revolving."
- Purchase Financing
- Secured Purchase Financing: Often large purchases such as houses and vehicles are made with secured financing.
- With this type of transaction, the loan balance is secured by the purchased item or property — a mortgage in the case of a house or a lien recorded on the title to the vehicle.
- The loan agreement gives the lender the right to take possession of the collateral (e.g., the house or car) if the buyer does not comply with the terms of the agreement. The lender can resell this collateral in order to reduce its loss from the unpaid portion of the debt.
- The advantage to a borrower of secured financing is that the cost is normally lower. The lower cost is the result of the availability of the collateral, which serves to reduce the lender’s risk.
- The inclusion of collateral and the resulting reduced risk to the creditor may also allow the transactions to be approved more readily.
- Unsecured Purchase Financing: The purchase of smaller items, such as appliances and furniture, are also frequently financed. These less costly purchases are often financed on an unsecured basis, without the use of collateral.
- Unsecured financing typically carries a higher interest rate because the risk of loss to the creditor is greater.
- The advantage of unsecured financing is that it is a simpler transaction because there’s no need to legally file a lien on the collateral.
- The disadvantage is that the credit approval is judged solely on the borrower’s creditworthiness, which in some cases could make it more difficult to approve.
- The increased risk is often mitigated by higher interest rates.
"It's easy to lose track... It's easy enough just to throw
down a card and forget about it and then you get that bill a few weeks later."
