Credit enables people to obtain goods or services even if they do not have enough money to pay for them right away. For example, a person who cannot immediately pay the full price of an automobile or a house may make the purchase on credit.
The word credit comes from the Latin word credo, meaning I trust. Moneylenders trust borrowers to pay them back. Sellers extend credit to buyers because it increases sales and, ordinarily, the buyers pay interest. Buyers are willing to pay interest for credit because in this way, they can use things they want while they are still paying for them.
A credit rating establishes the extent to which a person or company can buy on credit or borrow money. Factors that contribute to a credit rating include income, financial reliability, and records of previous credit transactions. Organizations called credit bureaus compile credit ratings and provide this information to stores, business firms, and lending institutions.
Credit can promote economic growth and contribute to a nation’s wealth. Business companies use credit to build factories or to buy equipment in order to increase the production of goods. Governments use credit to build schools, highways, and other public projects.
Types of credit.
There are three major types of credit—consumer, commercial, and investment.
Consumer credit
enables consumers to spend more money than they have at the time. A charge account is one kind of consumer credit. Most charge accounts involve no interest, but the full price of items bought through a charge account must be paid monthly. If the full amount is not paid by the specified date, many charge accounts require interest payments. Most businesses that provide charge accounts give their customers credit cards to make credit buying convenient. Banks also issue credit cards that can be used to charge purchases at many stores, restaurants, and other businesses. Another kind of consumer credit is an installment plan. Payments for a purchase on an installment plan are made over a stipulated period of time and, in most cases, include interest.
Commercial credit
is used by companies to develop their business. They expect to repay the loans from their increased profit. Most of these loans are repaid within six months and so are called short-term credit.
Investment credit
is a loan paid back over a period as long as 30 years, or even more. This kind of loan is called long-term credit. Examples include home mortgages and corporate bonds. Businesses use investment credit to undertake a major project, such as the construction of a factory.
Lending institutions
take money received from savers and other customers and lend it on credit to those who need funds. Such institutions include banks, savings and loan associations, credit unions, finance companies, and insurance firms.
The terms of a loan are set forth in a loan contract. These terms include interest, maturity, and collateral. Interest is paid by the borrower to the lender. It serves as compensation for giving up the use of the money, for waiting for repayment of the loan, and for risking the loss of the money. Maturity is the date by which the loan must be completely repaid. Collateral is something of value that a borrower pledges to the lender in case the loan is not repaid as promised. For example, the title of a house is the collateral on a home mortgage.
Credit and the economy.
The availability of credit affects both the rate of economic growth and the level of prices. When credit is easy to get, people are able to buy more, and their demand for goods and services grows. In response to the growing demand, business companies may try to hire more workers to increase output. Credit also enables firms to buy new equipment to boost production. However, if output does not keep pace with demand, prices will increase. A continuing increase in prices is called inflation.
During periods of inflation, moneylenders may hesitate to grant credit. Inflation drives down the purchasing power of money, and so the dollars that lenders get back buy fewer goods and services than those they lent. If lenders expect a period of inflation to continue, they may raise interest rates to make up for the loss in money value. When credit becomes harder to obtain, economic activity may decline, and inflation may slow down or even stop.
